About a month ago, Chinese financing company LexinFinTech filed for an IPO slated to raise $500 million, and the prospects of investing in a rising Chinese company appeared appealing. But on Wednesday, Reuters reported that LexinFinTech had “slashed the size of its initial public offering to between $108 million and $132 million.” It would sell 12 million shares at a price from $9 to $11.
A price drop of this magnitude is all but unheard of with IPOs. But even at this price, the reason for this drop should make investors stay far, far away from this company. LexinFinTech uses a business model that while successful so far, makes them easy targets for the Chinese government and is morally problematic. While IPOs can be risky ventures at times, Lexin carries far too much to make them a worthwhile investment.
Microloans for iPhones?
Lexin considers itself one of the premier lending platforms in China, and over the past year has ballooned thanks to its focus on microloans and financial services. A look at its SEC numbers shows that Lexin’s revenue increased from 2.9 billion RMB in the first nine months of 2016 to 3.9 billion in the same time span in 2017. Most of this growth came from its financial service sector, where revenue rose from 1 billion RMB to 2.1 billion.
Lexin targets young individuals between the ages of 18 to 36, and claims that they are helping these young people get credit and establish good credit histories at a time when Chinese banks are less willing to lend. But anyone who thinks these loans are a good deal for Chinese youth should realize that Lexin charged an APR of 25.3 percent for their on-balance sheet loans, with each loan lasting nine months.
Furthermore, many of these loans are used not to buy homes or start a business, but to buy consumer gadgets. A profile of Lexin by TechWire pointed out that Fenqile, Lexin’s online platform, saw huge jumps in use during a Singles’ Day shopping spree and that the iPhone X was the top choice among consumers using the Fenqile platform.
Lexin’s revenue has risen thanks to this emphasis on consumer lending, and its net income numbers have been moving in the right direction as well. While it reported net losses in 2015 and 2016, the losses steadily shrank before reporting a net income of 139 million RMB in the first nine months of 2017. However, the problems with giving young Chinese citizens loans at a 25 percent interest rate so they can buy iPhones with installment loans should be obvious. Lexin wants to brush aside these concerns by stating that with their algorithms and data models, they can better assess credit risks than banks. But even if Lexin can accomplish this, there are horror stories of Chinese citizens trapped by other microlenders or outright loan sharks into a cycle of debt. Household debt in China has been rising even before microlenders like Lexin and Qudian Inc (NYSE:QD) rose within the last few years, and the Chinese government is under pressure to keep debt down by cracking down on these businesses.
Fearing a Crackdown
In November, the Chinese government began the crackdown. As Bloomberg reports, China has stopped issuing new licenses to new microlenders, has forbidden banks from buying these new loans from the microlenders, and has banned turning these loans into securities. This follows regulations imposed last year which also sought to regulate online financial activities and lending.
Other microlending companies like Qudian and PPDAI Group Inc (NYSE:PPDF) have seen their share prices collapse as a result, and Lexin has reacted by slashing the IPO as discussed above. But there is far more reason to think that China will continue imposing additional regulations to crack down on microlenders. In fact, microlenders exist in part because China imposed more stringent lending requirements on banks partly to lower household debt and frivolous spending. If microlending encourages that, China will impose similar conditions on them.
Lexin in its SEC filing explicitly noted that “The laws and regulations governing the online consumer finance industry and microcredit companies in China are developing and evolving rapidly” as a potential risk factor and makes it clear that it will comply with regulations. But this threatens a company whose own growth was created due to Chinese regulations on banks.
Regulatory Uncertainty and High Risk
An IPO with both its net income and revenue going in the right direction would normally be worth serious consideration, especially as investors have a heavy interest in Chinese companies. But while Lexin may be successful now, its decision to massively slash its IPO size speaks volumes to its own confidence. Perhaps Lexin may be successful under a new Chinese regulatory regime, but there is far too much uncertainty for that to be a good bet. Investors right now should ignore a company which will be forced to change and adapt new lending practices which will likely negatively affect its bottom line.