Morgan Stanley RESEARCHFOUNDATIONDecember 10,201809:05 PM GMTChina Financials Asia PacificJohn CaiEQUITY ANALYSTChina P2P Growth ConstraintsJohn.Cai@morganstanley.com+8522239-1885Richard Xu,CFAEQUITY ANALYST+85228486729To Stay in 2019Joey XuRESEARCH ASSOCIATEJoey.Xu@morganstanley.com+8523963-0337Cleaning up the industry will be the regulatory focus in 2019,LuLuEQUITY ANALYSTand retail funding caps will continue to constrain growth forLu.Lu@MorganStanley.com+8522239-1568Listed players.We prefer companies with good earningsKatherine LiuRESEARCH ASSOCIATEvisibility and sustainable,compliant businesses.We initiate onKatherine.XH.Liu@morganstanley.com+8522239-1924Weidai at OW,and Lexin and PPDai at EW.China FinancialsAsia PacificIndustryViewAttractiveThe clean-up of smaller platforms will remain the regulatory focus in 2019,andLarge Listed P2P players will continue their operations even as Loan growth isWhat's ChangedFROMconstrained by the regulatory cap on retail funding.We believe the on goingYirendai (YRD.N)clean-up is unlikely to lead to a downturn in the credit cycle for most ListedPrice TargetUs$23.60Us$15.50players.The closure of small-/mid-sized platforms is unlikely to have a negativeX Financial (XYF.N)Price TargetUs$6.50impact on the asset quality of P2P platforms offering small ticket size productsChina Rapid Finance Ltd (XRF.N)as different products target different borrower bases.P2P platforms with large,Price Targetunsecured loans and Long tenure products,such as Yirendai (YRD),are Likely toexperience asset quality pressure from the clean-up.However,the asset qualityof Large listed platforms still hinges on macro risk,as borrowers'ability to repaywould be hurt if the unemployment rate rises.We expect the registration processto start after the clean-up ends,which could be in 1H20 or Later.Valuation overhang on P2P stocks to continue in 2019 as structural issues stillunresolved.The structural issue facing P2P platforms in China is that theyprovide unregulated credit guarantees to their funding providers.This is unlikelyto be resolved in 2019 and will continue to pressure P2P stock valuations,in ourview.We believe the Likely policy options could lead to notable downsideearnings risks within the P2P industry.We see two major outcomes:1)P2Pplatforms pass on all risk to investors and operate as brokers/asset managers,Likely Leading to lower take rates and a more Limited pool of qualified investors,or 2)P2P platforms retain credit risks with proper regulation of capital/fundingsources/risk appetite,leading to likely lower returns on Loans and leverage.Stock picks.We like P2P stocks with short-term earnings visibility in spite of theLoan balance cap,a manageable credit risk outlook,and long-term sustainabilityMorgan Stanley does and seeks to do business withcompanies covered in Morgan Stanley Research.As awith compliant APR pricing (i.e.Lower than 36%on an IRR basis)and strength inresult,investors should be aware that the firm may have aborrower sourcing.Weidai is our top pick for its earnings visibility and position inconflict of interest that could affect the objectivity ofMorgan Stanley Research.Investors should considerthe underserved micro and small enterprise (MSE)segment.We also initiate onMorgan Stanley Research as only a single factor in makingLexin and PPDai at EW.their investment decision.For analyst certification and other important disclosures,Key risks:The main risks to our view are smoother-than-expected progress onrefer to the Disclosure Section,located at the end ofthisthe clean-up,Leading to a change in the retail funding cap,or earlier regulatoryAnalysts employed by non-U.S affiliates are not registered withaction to resolve structural issues,which could pose downside risk to earnings.FINRA,may not be associated persons of the member and may notWith this report,John Cai also assumes coverage of Yirendai (YRD.N),X Financial(XYFN)and China Rapid Finance (XRFN).Morgan Stanley RESEARCHFOUNDATIONOrder of preferenceExhibit 1:P2P stocks-Order of preferenceChina RapidWeidaiLexinPPDaiYirendaiX FinancialFinanceWEI.NPPDF.NYRD.NXYF.NXRF.NRatingOver-WeightEqual-WeightEqual-WeightEqual-WeightEqual-WeightUnderweightTrading CurrencyUSDUSDUSDUSDUSDUSDPrice Target13.09.55.515.56.51.310.08.15.014.6641.6Upside/(Downside)(%30%17%10%6%2%-19%Market Cap (in USD mm)7011,3401,503888967105Avg Daily Traded Val (in USD mm)045.9123.80.60.2Street View:Ratings0%86%50%27%0%0%0%50%64%0%0%0%0%67%Bull Case Value14.711.46.220.88.01.9Upside(%)47%41%24%42%25%19%Bear Case Value9.6784.610.8510.6Downside(%）4%4%8%-26%-20%Risk/Reward Skew11.811.03.01.61.20.3Valuation Multiples at Last CloseFY18e7.6x7.7x7.9xn.mP/sales12x24x1.1x1.8x1.0xFY19eP/E7.27.1xn.mP/sales1.1x1.5x1.1x1.7x0.8xImplied Multiples on MS Price TargetFY18e9.8x10.1x7.9x8.0xnaP/sales1.6x1.8x28x1.9x1.17×FY19eP/E8.1x6.3x7.8x72xnaP/sales1.5x1.9x1.4x0.71xStock Price Performance(2.3%(19.2%(13.0%)(18.0%)(15.6%(35.6%(2.3%(20.1%(19.6%)(46.5%(33.7%YTD(41.8%(6.8%)(46.5%(71.9%Source:Morgan Stanley Research,Thomson Reuters(oonsensus mean).e=Morgan Stanley Research estimatesNole:Past performanoe is no guarantee of future results.Results shown do not indude transadion oosts.Morgan Stanley RESEARCHFOUNDATIONKey chartsExhibit 2:Structuralissue of implicit guarantees likely to remainExhibit 3:Our top pick,Weidai,is a market leader in P2P auto backedunresolved in 2019 as regulators focus on cleaning up smaller playersloans serving MSEs,with earnings visibility and a sustainable,compliant businessTimeline20192020Rmbbn37.6%RegulatoryModeClean up100.090.040%94.835%PolicyRisks preventions and closureEntry requirements and the80070.030%Objectivesof small/mid sized platformsongoing monitoring60.025%50.054.720%RegulatoryNational Online LendingCBIRC and Local Finance15%LeadershipRectification OfficeAuthority35.6%Impact on10.017.2%Resolve structural issues ofqualityP2P loan balance capimplicit guaranteeVolume in 1H 18Balance as of 1H18platformsExpectedP2P Auto loanWeidai auto backed loanTimetableAfter the clean up◆一Weidai Market Share(RHs)uce:Morgan Stanley ResearchExhibit 4:Based on our sample of 116 P2P platforms,most offerExhibit 5:...and they also target different borrowers than most listedlarger loans of more than Rmb40k per borrower...platforms,which tend to offer loans of less than Rmb10kOutstanding loan per borrowerby outstanding amount per borrower,as of 1H1853%70(Rmb,as of Oct 2018)50%50.00047,8726045,00041,97740%40,0003500030%22%3030.000179%20%25,0002020,00010%621015,0008,932205,7574,3470%3,2385000<10k10k to 40k40kto 100K>100K■No of platforms(RHs)of total platforms in our sampleYirendaiWeidaiPPDaiChina RapidFinancee NEAExhibit 6:P2P is likely to evolve into a lender/asset manager/broker business model with furt her regulatory clarityP2P business model'Asset Manager'Current mode"Lender"model"Broker"modelmodelManagement andNature of P2P revenueInterest spreadCommissionperformance feeInvestor baseOnline retail investorsInstitutions only if reference toconsumer finance or micro loanindividuals)or InstitutionsPo licy choicesInvestor Return volatilityLimitedto revolveLimitedHighP2P exposure to risksUpsideFullguaranteeFullPartialNoneof underlying assetsDownsideFullFullNoneNoneP2P platforms providedUnder a formal capital /leverageFunding providers decide whether toCredit enhancementimplicit guarantee out ofrequirement,P2P platforms raisedprocure third party guarantee/creditfunding as its own liabilityinsuranceBusiness model disruptionNALowHigh3Morgan Stanley RESEARCHFOUNDATIONInvestment summaryRegulatory outlook:Structural issues unlikely to be resolved in2019We expect the regulatory overhang on P2P stock valuations to persist in 2019,as thestructural issue of providing unregulated credit guarantees to funding partners isunlikely to be resolved.Most of the quality P2P platforms still offer various guaranteesto their funding providers,either directly or indirectly (such as through reserve funds orsecurity deposits).By using their own equity to ensure funding providers get guaranteedreturns,P2P platforms are effectively acting as 'credit intermediaries'in a similar way tobanks,but without the proper capital/leverage requirements.P2Ps typically charge highinterest rates,which indicates that most have a higher risk appetite when sourcingborrowers.However,they are funded by retail investors with a low risk tolerance,resulting in a mismatch.This mismatch leads investors to rely on platforms'reputationsor equity to support debt repayments regardless of the risks to the underlying assets.As a result,we believe the profitability of quality Listed P2P platforms will remain strongas they are operating like banks(taking credit risk with retail funding)but are not beingregulated as such.Despite this,their valuations are under pressure owing to theregulatory overhang,with stocks trading at an average 2019 P/E of 5-6x.We do notexpect these structural issues to be resolved in 2019,so the regulatory overhang willcontinue to weigh on valuation sWe expect the P2P registration process to start in 2020 or Later.While it is difficult toforecast the timing and details of regulatory moves,we see two phases ahead:1)theclean-up process and 2)the registration process.The current clean-up process started inAu gust 2018 when the regulators undertook a regulatory in spection after several P2Pplatforms failed in July and August.We expect the clean-up process to take anotheryear,reaching completing in 1H20 or Later,with the registration process starting afterthat.We believe the declining number of P2P platforms will be key to watch to assessthe progress of the clean-up.After the completion of the clean-up process,we expect regulators to take furtheraction to address the structural issue of implicit guarantees by quality listed platforms,and thus make further progress towards registration.We see the potential for twomajor policy directions,both of which would have negative Long-term implications,particularly on eam ings for P2P players.1.Lender model:We believe this would be a better scenario for P2P platforms,asthey would be able to continue their current business model,i.e.eaming an interestrate spread and taking credit risk.However,for current non-bank Lender Licenses,such as for consumer finance or microlending companies,their funding sourceswould only be able to come from institutions,and they could not take publicdeposits.We also expect formal capital or leverage requirements,which mightconstrain gearing,and tighter interest rate caps to prevent excessive risk-taking.2.Asset manager or broker model:We believe this is more likely given the currentMorgan Stanley RESEARCHFOUNDATIONregulatory positioning of P2Ps as'information intermediaries'.Conceptually,thismeans an intermediary that only provides information-related services such assearches,releases,credit information exchanges,and credit matching).We expectthe P2P business model to be disrupted,as its funding base is likely to shrinksignificantly due to qualified investor requirements,which will Limit the pool ofpotential investors to high net worth individuals and institutions.The revenuemodel would change from interest spreads to management fees/commissions,which we believe would be much lower.Exhibit 7:Different policy choices to resolve implicit guarantee issues will lead to different level of business modeldisruption and negative impact onearningsLowHighLikely to stay in 2019Negative earnings impactP2P business model"Asset Manager"Current mode"Lender"modelmodel"Broker"modelNature of P2P revenueManagement andInterest spreadCommissionperformance feeOnline retail investorsInstitutions only if reference toQualified investors (High net worthindividuals)or InstitutionsPolicy choicescompanyLimitedLimitedHighP2P exposure to risksUpsideFullFullPartialguaranteeNoneof underlying assetsDownsideFullFullNoneNoneP2P platforms providedUnder a formal capitalFunding providers decided whether toimplicit guarantee out of/leverage requirement,P2Pprocure third party guarantee/creditCredit enhancementits own equity.platforms raised funding as itsinsuranceown liabilityBusiness model disruptionNALowHighExposure to underlying credit risksHighLowIn Light of these potential regulatory changes,we believe P2P platforms with strength insourcing borrowers/assets with better risk-adjusted returns will be able to sustain theirbusinesses in the long term.We also favor platforms with compliant annual percentagerate (APR)pricing as they have fewer downside risks from potential interest rate caps.Weidai fits both criteria,as it has offline branch networks to source borrowers andassess credit risks,which we think will allow it to differentiate its business model,andalso its APR charged is relatively Low at around 30%For a more detailed discussion of regulatory issues,please see:Key regulatory issues tobe addressed prior to registration.Clean-up vs registration:Different effects on different playersThe ongoing clean-up of online Lending,as part of the overall financial system clean-upeffort in China,is being led by the National Online Lending Rectification Office,adedicated taskforce which includes multiple government departments,includingfinancial regulators and police.We believe its aim is to prevent and reduce risks with afocus on closing non-compliant platforms and reducing the number of platforms to amanageable Level of around 200-300.Stability remains a key constraint on executiongiven the Large number of retail investors involved.We believe the clean-up process willLikely be completed in 1H20,which would Leave around one year for outstanding loansoriginated by non-compliant platforms to mature so as to ensure orderly Liquidation and