Rebecca Byrne

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Among Consumer Lenders, Safety Counts

Rebecca Byrne

With personal bankruptcies on the rise and more consumers defaulting on their loans, it's become a tough environment for credit card lenders. But as Thomas Weisel analyst Matthew Park points out, not all consumer finance firms are equal.

Although subprime lenders, companies that lend money to people with checkered credit histories, are likely to endure further pressure in the months ahead, Park believes that prime lenders should fare much better. As a result, he raised his investment rating on MBNA Corp.(KRB Quote) to buy from attractive, and downgraded Household International (HI Quote) to market perform from buy on Monday.

"We suggest the valuation of prime consumer lenders would likely be more resilient to further investor concerns over consumer credit," he said in a research note. "We believe that most of the remaining credit quality issues are in the subprime area."

Household, which caters to high-risk borrowers, stands in contrast to MBNA, whose average customer has an annual income of $70,000 and a 17-year history of paying bills on time.

One of the main reasons that MBNA is expected to do so much better than its rival is that its credit quality is projected to improve significantly in 2003. During the third quarter, MBNA's net credit loss rate, or the percentage of its lending portfolio that is not expected to be repaid, declined to 4.84% from 5.09% in the prior quarter. Park expects this to fall to 4.57% next year.

At Household, net credit loss rates of real estate secured loans, which account for more than 45% of its total managed portfolio, are rising faster than expected, hitting 1.03% in the third quarter, up 17 basis points from the second quarter and 38 basis points from the first.

MBNA is a better investment for other reasons, too, according to Park. The firm's expansion into the U.K. has helped offset domestic weakness in loan growth. In addition, the stock is undervalued, trading at 11.3 times Park's 2003 earnings estimate and 3.1 times book value. Historically, shares have traded at 14.8 times forward earnings and 4.8 times book value.

Although Household's valuation is also well below its historical average, Park said the stock lacks a near-term catalyst in the form of stabilizing credit losses or substantially faster loan growth.

"The risk profiles of its receivables and earnings have increased, even though the regulatory risks, the previous focus of investors, have abated," he said.

Last week Household said it would pay up to $484 million to settle allegations that it had engaged in predatory lending practices. Customers complained that the firm deceived them into accepting unfair loan terms, and despite the settlement, Household still faces potential class-action lawsuits in three states.

Still, Park said he is more concerned about the aforementioned increase in credit losses and he noted that higher revenue from securitizations has increased the volatility of future earnings growth.

Revenue contribution from asset securitization -- or the pooling and selling of loans -- saw a large increase in the third quarter worth around 9 cents a share. It's expected to remain at a high level because of the firm's attempts to diversify its funding and liquidity.

"We believe that the material reliance on securitization revenues is likely to be a drag on [the] relative valuation of Household shares during this transition period," he said.

Park cut his 2002 and 2003 earnings estimates on Household but increased MBNA's estimates for this year and next. Although an increase in personal bankruptcies remains a "key risk" to his projections, Park did note that underlying consumer credit quality trends are improving and said an industrywide tightening of underwriting standards should reduce the level of overall loan defaults "even if the economy does not improve rapidly."

Like other subprime lenders, Household's shares have been pummeled this year, falling 50%. The stock ended down 2.7% to $28.40 on Monday. MBNA, on the other hand, has held up better, with a decline of just 14% year to date. Shares closed up about 1.5% at $20.20.