Financial Services balance sheets – the rising danger to equities
* Financial Services biggest risk. We see several factors in place that could provide the perfect storm for OEMs' Financial Services units in a potential downturn, a risk which seems largely ignored by the investment community. Over-earning in FS sets the foundation for strong growth with an inflated upcycle. The danger is that a down-cycle could last longer with bigger losses, since the starting point is worse than previous cycles. Simultaneous weakness of the industrial business could accelerate the equity de-rating, as capital injections into FS will likely be more challenging. German OEMs are most at risk, particularly VW (UP). We reduce our target prices for all the stocks under our OEM coverage to reflect the cuts to our earnings forecasts.
* This time, it could be worse than 2009. Post 2009, FS companies enjoyed a highly favourable environment with windfall gains on residual values, aggressive cost ratios and cheap financing. The inflated up-cycle since 2009 left the industry with less profitable contracts and overstated residual values vulnerable to weakening market dynamics. Thus, the starting point is much worse than in 2009, and a downturn is likely to be both longer and deeper
* Residual value assumptions are too optimistic. The most important driver for Financial Services is the residual value assumption. Based on our comparisons between marketed leasing contracts and market prices of used vehicles (using Schwacke in Germany), we find the residual values are not conservatively valued relative to market prices, which are at peak levels, leaving little room to absorb the impact of falling used car prices. The OEMs now risk under-earning on the down-cycle.
* FS strategies determine resilience to risks. Financial Services can be captive as in the case of the German OEMs and Renault or via JVs and partnerships, as with PSA and FCA. We see bigger risks at captive businesses which over-earned in the up-cycle (German OEMs expanded the FS balance sheet most aggressively, up 63% since 2008, with VW up 83%). We view the strategy of PSA and FCA as more resilient in a downturn