1QFY13 earnings in line with our estimates. AEON Credit recently reported annualized earnings that were slightly  below  our  forecast,  accounting  for  93.8%  of  our  full-year  forecast.  Its  net  profit  grew  46.4%  y-o-y, underpinned  by  stronger  operating  income  from  its  credit  card  business  (+34%  y-o-y)  and  the  personal financing business (+112% y-o-y). Given the positive picture painted by management during our recent event, we  expect  that  the  company  would  be  able  to  sustain  its  performance  moving  forward,  supported  by  its business strategies, marketing and branding efforts.

Solid  management  team,  with  support  from  Japan  parent  company.  Most of AEON Credit's senior management personnel have been with the company for more than 10 years and continue to play a crucial role in the group. We also understand that all the company's major business policies and decisions are made in close consultation with AEON Credit Japan. It has also been able to reap synergistic benefits as part of the larger  AEON  Group  and  we  believe  that  this  will  last  as  long  as  it  remains  within  the  AEON  Group  of Companies.

Shift to middle-class lending lowers risk profile. Management added that it is changing its focus from low-income customers who primarily use its cards for cash advances to middle-class customers who use its cards for purchases. It roped in these customers via its internal database and partnership with AEON Co, whereby the duo share their database to tap on lucrative cross-selling opportunities. We understand from management that it does not pay any fees to AEON Co for sharing its customer database. Although this client base is more price  sensitive,  which  translates  into  lower  net  interest  margins,  it  is  also  considerably  more  credit-worthy, thus  essentially  reduces  the  overall  credit  risk  of  its  receivables.  Nonetheless,  its  overall  profit  will  still  be preserved as management intends to increase the average loan amount to this group of customers. 

Riding  on  ties  with  AEON  Co  to  grow  credit  card  business.  AEON  Credit  currently  has  more  than 160,000 credit cards in circulation (market share of 2% based on Bank Negara Malaysia statistics in April). It has also issued more than 823,000 Express Cards (privilege card offering benefits and privileges) to selected customers. While times are challenging for the credit card business, management would continue to grow its credit  card  issuance  by:  i)  actively  converting  its  Express  Card  members  to  AEON  Card  members  via  its activation  programmes,  ii)  recruiting  new  customers  at  AEON Co's shopping malls, and iii) leveraging on AEON Co's member programme,  which  has  some  900,000  members  in  its  database.  It  is  also  planning  to offer  platinum  cards,  in  addition  to  the  classic  and  gold  cards,  in  2HFY13,  in  tandem  with  its  strategy  to acquire more middle-class customers. We believe that AEON Credit's credit card base could easily hit 170k-180k this year, with revenue from this segment expected to pick up on the back of a higher card activity ratio and better average spending per card, supported by its activation programmes.

Maintaining  grip  on  vehicle  financing  business.  AEON  Credit  has  historically  done  well  in  vehicle financing  (motor  easy  payment)  for  purchases  of  low-end  automobiles  such  as  Demak  and  Honda  but  has recently ventured into superbike and used car financing. Although there are no official statistics, AEON Credit finances approximately 11%-13% of new motorcycle registrations in Malaysia. In our view, it will continue to dominate the low-end automobile financing business as it has strong partnerships with the various merchants through a network of more than 900 dealers, a competitive advantage it has established since inception. We think  that  its  entry  into  the  used  car  financing  market  may  pay  off  if  it  is  able  to  replicate  its  solid  risk containment measures in the new venture. This is a segment that the banks do not generally compete in and where  the  margins  are  higher  than  for  new  car  financing.  While  the  receivables  for  its  used  car  business remain  small  at  only  4%  of  its  total  receivables  as  at  1QFY13,  we  believe  that  there  may  be  a  need  to increase  its  funding  needs  if  this  foray  takes  off  in  a  big  way  due  to  the  larger  loan  size  compared  to  the company's existing ones.

Personal  financing  growth  to  remain  robust.  AEON  Credit  has  been  growing  its  personal  financing business  aggressively  lately.  The  financing  receivables  for  its  personal  financing  business  grew  by  184.7% from FY09 to FY12. We expect it to grow by a CAGR of 52.9% between FY12 and FY14, underpinned by its successful marketing  and  promotional  activities nationwide,  coupled  with  the low  base  effect.  This  business carries  higher  asset  quality  risk  due  to  the  non-collateralized  nature,  but  the  company  primarily  lends  to selected customers with favorable credit ratings, determined via proper data analysis using its internal credit scoring  system  and  the  Central  Credit  Reference  System.  The  average  loan  size  for  its  current  group  of customers  ranges  from  RM2,000  to  RM3,000  '  an  average  that  falls  below  the  radar  of  commercial  banks. While we believe that the group will be able to grow this business in a meaningful way given the relatively low credit  risks  associated  with  it,  we  will  monitor  its  non-performing  loan  (NPL)  ratio  closely  as  its  personal financing receivables have not been tested for resilience. Nonetheless, based on our estimates, we derive a theoretical  NPL  ratio  of  3.3%  and  5.2%  for  FY13,  assuming  10%  and  20%  of  its  personal  financing receivables are being classified as NPLs respectively.

Small  business  financing  for  selected  customers.  Management  added  that  it  sees  an  opportunity  in financing  business  owners  to  purchase  assets/equipments  such  as  machineries,  lorries  and  trucks  for business purposes. We understand from management that its stringent risk management assessments will be applied  and  these  loans  could  range  between  RM50,000  and  RM1,000,000.  Management  added  that  it  will not  finance  working  capital  applications  as  it  sees  the  purchase of assets  as  a  risk mitigation precaution  by itself.

Venture in India pending regulatory approval. We understand that AEON Credit teamed up with Edelweiss Capital  to  set  up  AEON  Credit  Service  India,  as  part  of  its  expansion  plans  in  Asia,  with  an  initial  capital expenditure of some USD7m. The subsidiary is set up with the aim of tapping  into India's growing economy, which it identifies as a key market where it can replicate its successful business model. We do not expect any contributions from its venture in India for the next three to four years as managements intends to devote the first three years to establish a proper infrastructure and study the market behaviour of the consumers in the country.

Margins  stable  for  now.  Interest  margins  are  high  and  show  little  sign  of  deterioration,  particularly  since most  bank  competitors  are  not  competing  directly  with  its  business.  The  low  interest  rate  environment  also benefits its funding cost which stands at some 4.2% as at 1QFY13 (Our forecast for FY13 and FY14 ' 4.5%). We  believe  that  the  high  interest  rates  it  earns  (23%-25%  on  average  across  all  products)  will  cushion  the impact if its funding cost increases and thus maintain its strong net interest income. Management also shared that its funding strategy will be based around maintaining a larger portion of long-term liabilities to capitalize on  the  falling  rate  environment,  similar  to  the  strategy  of  its  sister  company  in  Hong  Kong.  Its  long  term borrowings stood at 83.2% as at 1QFY13 compared to 71.8% in FY11 and 79.3% in FY12.

Dividend yields still decent despite the strong rally.  AEON Credit has an attractive gross dividend yield of  4.4%  and  5.6%  for  FY13  and  FY14  respectively  based  on  its  current  share  price  of  RM11.26.  As mentioned, the company is very well capitalized and we expect a net dividend payout ratio of 37.0% for both FY13 and FY14 respectively.

Maintain  NEUTRAL.  We  had  downgraded  the  stock  from  a  BUY  to  NEUTRAL  at  the  time  our  ASEAN Corporate Day was held. As the stock has rallied by some 28.4% up to yesterday since we upgraded our fair value in April, we deem the stock fairly valued at 10x on its 12-month forward PE. While we are making no changes to our earnings forecast, we believe that the company would continue to deliver respectable loans growth while keeping its asset quality intact via prudent risk management. We believe there is more upside potential  given  its  superior  earnings  growth,  ROE  and  ROA  compared  to  its  parent  and  sister  companies, This  could  prompt  a  rerating  in  the  stock  price  to  11-12x  PER.  At  11x  and  12x  forward  earnings,  our  fair value would be at RM11.77 and RM12.84 respectively. Our view is that the stock should trade at valuations above  its  sister  companies  in  Thailand  and  Hong  Kong  (both  of  which  have  lower  ROEs  and  ROAs)  but below that of its parent company.

Source: OSK