Where the finance company sector is headed in 06
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Comment by www.interest.co.nz
Release date: 4 April 2006
Where the finance company sector is headed in 2006
Finance companies are an important part of the investment landscape and, with over 60 institutions offering a range of retail deposit opportunities, they have become a unique option for investors in New Zealand.
Over $10 billion is now deposited in them, both directly by individuals, and collectively through investment adviser recommendations, and as such it is important to regularly assess both the whole industry, and individual institutions, to ensure they are, and likely will, meet the investment standards set and expected by depositors.
Before assessing where this group of institutions is headed, we need to review where they have come from and how they got here.
Finance companies have enjoyed a prosperous run over the past five years. The numbers of them who offer deposits have grown from 44 to 62 over this time. Despite being subject to heavy criticism by their competitors, almost none have succumbed to insolvency in this period, somewhat in contrast to the up and down experience of managed funds.
Growth in total loans and advances has been very good, averaging +16.6% in 2005, although this was down from +18.5% in 2004.
Quality measures, available from public information, have also improved somewhat.
This has enabled them as a group to raise funds from the public at an impressive rate, paying a rising return.
Shareholder capital has kept pace with this heady growth, enabling gearing to reduce from 9.6 times to 8.9 times over the last three years. And, this compares very well with banks over the same period, which collectively increased their gearing from 14.3 times to 15.9 times.
Capital adequacy, as measured by Tier 1 capital has improved for finance companies, although it is hard to draw the same conclusion for banks.
Impressive growth and operating performance in the 2003 to 2005 period counts for a lot - especially with the improving capital ratios - but the real question for observers is what 2006 will bring.
There is little doubt the New Zealand economy will slow, with GDP growth tipped to be anemic this year. The exchange rate correction, predicted for so long, has started, and this will benefit exporters if sustained. But it will also generate 'imported inflation', so the RBNZ mandated responses will keep the cost of money high for quite some time.
Finance companies will face different pressures and reduced opportunities in 2006 and 2007, as will most other non-exporting businesses. Individual company strategies are about to be tested in a way they have not been over the past 4 or 5 years.
The markets for finance company products will offer less opportunity. Here is our assessment.
Rising inflation without growth will curtail a number of business opportunities. But high public sector spending will continue unabated, especially on income transfers ("Working for Families") and major infrastructure projects. Exporters may see gains after a year or so of a sustained lower fx rate. However, the 'wealth effect' for city dwellers from the property boom is likely to disappear.
This sector may see growth opportunities reduce fast. Activity won't stop, and low vacancy rates for office accommodation will keep some projects progressing, but financing opportunities are likely to be less, and competition for those that remain, more, as 2006 develops.
Property – residential
For finance companies, this means investment property, and demand here is expected to be considerably weaker. Vacancy rates are rising and rental returns falling. Finance companies heavily exposed to this sector face low opportunity for growth, and difficult project management.
Tougher trading conditions for these clients will undoubtedly mean lower quality financing opportunities, even though demand may increase. Banks are likely to reject more applications, so volumes may go up for finance companies while quality could wobble.
It is starting to get reasonably tough now, and it will get much tougher before the benefits of the lower dollar kick in. Imported inflation will hurt agri-businesses well before higher NZ$ returns flow through the system to cover them. Only committed, patient, and expert finance companies will be able to tolerate the coming conditions.
This sector needs to be reviewed in a range of categories.
Car financing is likely to get tougher. Not only will volumes be lower, competition for the usual sales channels (dealers, auctions) will get very tight from on-line trading (Trade-Me, Autopoint, etc.). This will work to squeeze margins, and lower the quality of finance contracts. We expect much higher levels of loan provisioning will be required.
Consumer durables could hold up quite well, but probably won't grow a lot. However, 'sticker shock' may become an influence not well understood by retailers, and imported inflation may see trading levels plateau. After all, the price effect of a 1c exchange rate drop at NZ$1=US$0.60 is 15% higher than at NZ$1=US$0.70. It is unclear whether this will be 'good' or 'bad' for the volume of credit contracts entered into, and it could go either way. It is also worth remembering that GE Money is the 'elephant' in this patch, and finance companies wanting more exposure to this sector will need to work very hard to ensure they are not left with low quality contracts.
Low-ticket financing will almost certainly get tougher if the fall in economic growth raises unemployment significantly. It is not hard to see increasing payoffs as the economy slows. At what point rising unemployment affects low-ticket financing is unknown, of course, but when it happens it will be affected by consumer psychology, and happen quite quickly. Finance companies in this sector will know that being 'slow and tolerant' will be a fast way to get a very large number of arrears and defaults very quickly. This can overwhelm both their provisioning, and their back-office capacity to deal with such a crisis in client financial quality. We doubt such a scenario will become pervasive, but, again, it will be the slowest to react that will suffer the most. There are no benefits to ignoring early signals. Smart operators are undoubtedly raising credit quality standards now.
General – II
And then there is Kiwisaver. 2006 and 2007 will see an expensive government advertising program about the wisdom of saving. Every dollar diverted to this program will create both risk and opportunity for finance companies. Consumers will feel more 'spending constrained' as they start on such a path. Pay packets will be lighter by the amount diverted to such saving, and a negative 'wealth effect' could take hold. Undoubtedly, some will cover such savings by entering into finance contracts for items they may have saved for previously, or offer a greatly reduced deposit. In some sectors, finance opportunities may go up, but undoubtedly quality of these applications will be lower. The pressure on consumers to 'save' in the Kiwisaver programs will be strong – the government is committing many millions to an aggressive advertising program, and the Retirement Commission will organise its ad spend to compliment the program. Workplace pressure will be relentless as well.
When growth goes out of a market, the normal reaction is to restrain further exposure to the sector you are in, and diversify into other exposures, to broaden the portfolio risk.
However, the coming low-growth period will probably see every player considering this strategy, and the consequence will be a significant heightening of competitive pressure. Already, banks are re-orienting their growth plans away from residential mortgage lending, with more focus on general business lending. Some finance companies (eg Provincial Finance) have announced a shift in their approach as well. Others are doing it without fanfare.
Competition is going to get tough in 2006 and 2007 for finance companies.
What should management do?
To be ready for these pressures, finance company management will need to focus on some key things. These will include:
- Compromise less on your credit quality standards, and raise those standards if necessary.
- Ensure your margin requirements are being met.
- Ensure you have the capacity to stay on top of existing loan contract performance. React early, and ensure you have the capacity to handle a significant increase in arrears or defaults.
- Ensure provisioning is adequate for a changed trading environment.
- Only diversify into areas your organisation has both the skill and capacity to handle, and where you can add real value for clients. Avoid me-to offerings.
Investors have different priorities.
They need to ensure they have a broad diversification to the various finance company sectors. Just being diversified between a number of different finance companies is of no value if all those finance companies are exposed to the same client sector.
Pick the sectors you think may have an easier time of handling slower economic growth, and lower your exposure to those who will have a tougher time.
Lower your priorities for a higher return, and raise your priorities for capital protection. Understand balance sheet strengths, balance sheet quality measures, and especially liquidity and maturity profiles.
There is no great harm in raising your 'risk premium' requirements, but in a no-growth environment financial fundamentals will offer the better protection
Individual depositors should use the services of a qualified investment adviser. Choose one that makes their selections, and bases their recommendations, on research.
2006 and 2007 will be challenging for depositors. Nobody knows whether there will be finance company failures. But they may be no more likely than managed funds or share equity failures. Finance company fundamentals have improved significantly over the past few years and most are in good shape going into a soft period.
It is now up to finance company managements to maintain these improvements in the face of slower opportunities. Confidence building measures will always help. These will include early release of trading results, and interim results - and, conspicuous increases in provisioning.
Depositors can help also, by seeking earlier reporting from companies who have accepted their deposit funds, and by staying loyal to companies who do the right thing by keeping strength and quality up, even if it is at the expense of short-term profitability.