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What’s the real risk in Ant’s IPO?

Hint: it’s not U.S.-China tensions, lending caps or becoming regulated.

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Ant Group filed for its blockbuster initial public offering in Hong Kong and Shanghai on August 25, promising a $200 billion-plus valuation. The expected listing of 10% of shares will raise at least $20 billion, with the lion’s share of that in Hong Kong.

The announcement has sent analysts and reporters scouring through its 500-page prospectus to focus on the risks.

So far, that focus has been twofold. First is regulation: can a tech company navigate both mainland China and global financial compliance needs? The second is U.S.-China political tensions. Both were prominently cited by Ant Group.

A third element came into play: over the past weekend, Bloomberg reported that loans made by non-bank consumer lenders, including Ant, will be not be allowed to charge borrowers more than 15.4%. Licensed banks face no such restriction.

This hits at Ant’s most lucrative businesses, but this is not the main risk to its business, given its strength in data and credit scoring.

The risk is Ant’s own business model, which is reliant upon revenues from financial institutions.

Which raises the question: what exactly is Ant Group?

A China-based analyst, Wu Xin of Beijing-based artificial intelligence website Machine Heart (Jiqi Zhineng), as translated by Jeffrey Ding of the ChinaAI newsletter, lays out the details as follows.

Why are profits modest?

Ant Group reported net profits of Rmb21.9 billion ($3.2 billion) for the first half of 2020. This puts Ant in the same revenue ballpark as China’s big banks, although its high technology and R&D costs mean it is a lot less profitable.

Compared to big banks, Ant is only modestly profitable, because it has huge operating costs that grow roughly in line with its business, so it can’t rely on business scale to overcome them.

Beyond R&D, the big factor is transaction costs Ant pays financial institutions to facilitate incoming transactions onto the AliPay payments network. The bigger the flows, money in and out of bank accounts, the greater the fees Ant pays the banks. To date, Ant has not raised the fees it charges those banks (or consumers) for its own services, therefore its margin is narrow.

What drives revenues?

Revenue comes from three business units. The largest of these is called the “digital financial technology platform”, accounting for over 63% of revenues. Most of these come from charging fees to its financial institution partners – that is, to banks, asset managers, insurers, and anyone else leveraging Ant’s services. 

The platform business overtook AliPay’s payments and business service revenues in 2019, thanks to microlending, wealth management (including Yuebao, its groundbreaking money-market fund), and insurance. (Vendor services like cloud and blockchain play a very small role in Ant’s overall revenues.)

Payments, says analyst Wu Xin, are the lifeblood of Ant Financial and the dominant position of AliPay, which accounts for 55.4% of China’s payments market, according to iResearch. (Tencent commands 38.8%.) These flows not only generate revenue for AliPay but more importantly give the company unrivalled access to the data of 700 million consumers and 80 million merchants, which Ant uses to fuel its credit system. This is Ant’s “unique martial art” and its greatest competitive edge.

What drives profits?

The most important use cases for that data and credit scoring are Ant’s microlending businesses on its digital financial technology platform. In the first half of 2020, according to Ant’s prospectus, microlending revenues reached Rmb28.6 billion, accounting for nearly 40% of operating revenue. This figure has increased by nearly 60% year on year, accounting for Ant Group’s ballooning figures.

Microloans account for a number of Ant products. The most important are called Jiebei (“spend it”) and Huabai (“borrow it”), which have driven the platform to extend Rmb2.1 trillion in credit.

It is not, however, Ant’s money that is being lent out. According to the prospectus, 98% of credit is extended by banks or issues of asset-backed securities (which is to say, the capital market funds the loan).

This is in keeping with Ant Group’s business philosophy: it is a technology company, not a bank. However, its powerful hold on payments funnels the data to give it the power of a highly competitive lender. (Not to mention provide competitive advantages to Alibaba, which owns 33% of Ant Group and embeds these financial products into its own app.)

What creates risk to Ant Group?

Microlending is the fastest-growing profit center in Ant Group. But Ant is dependent upon others to offer credit.

The IPO prospectus identifies the risk to Ant is not being able to maintain healthy partnerships with financial institutions, says Wu Xin. Will these banks continue to trust Ant even as it hoards all the customer data? As it becomes more highly regulated as a listed company in Shanghai and Hong Kong, will banks believe in Ant’s credit risk management?

Wu Xin says (according to Jeffrey Ding’s translation): “The microlending technology platform business is the backbone of Ant’s various business segments, and the policy risk is high.”

If enough banks and other financial institutions decided they didn’t want to do business with Ant, it would not be able to provide loans or other services.

What does this mean for investors?

How serious a risk is this? It is probably not a case of an industry boycott. The threat is that banks, brokers and asset managers will aggressively target Ant’s customers, impeding its ability to increase its userbase or, worse, engage more with its users.

Ant can blunt this threat by keeping its relationships with financial institutions sweet, which is why its operating costs are unlikely to be contained. If it’s to keep the credit tap open, it needs to keep paying banks for facilitating payments.

This could get difficult, however, in light of the new cap on consumer lending of 15.4%. If banks can get a higher interest rate, they might decide to invest in customer acquisition, or demand a greater fee for payments, or demand a greater return on providing capital to Ant’s microloan products.

In this context, regulation is already making Ant’s life more difficult, and U.S.-China political tensions will limit its cross-border payments ambitions. They are genuine risks. But they are secondary.

Despite Ant’s pioneering and dominant role in fintech, it may not be able to turbocharge profitability because it relies on financial institutions as much as they rely on Ant to distribute their credit and wealth products.

Indeed, Ant’s margin has been in decline over the past few years, as the prospectus figures show. Its tech and R&D costs are huge, and Ant is earmarking 40% of IPO proceeds to keep spending here.

Jack Ma built Ant this way, and through employee holding companies and his outright 8.8% stake, he will remain firmly in control of Ant Group. He is unlikely to change his mind simply to please minority shareholders.

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What’s the real risk in Ant’s IPO?