OneMain Holdings Shares Are Not Pricing In Enough Recession Risk (NYSE:OMF)

Last October, I argued that shares of OneMain Financial (NYSE:OMF) could reach $42-45 if recession fears moderated, though investors needed to be aware of its significant exposure to an economic downturn. Recession fears have gone down, with the Federal Reserve’s staff no longer predicting one this year. Accordingly, OMF shares are in fact trading around $42, making it an appropriate time to review whether investors should exit shares or continue to hold for more upside.

In the company’s second quarter results, the company earned $1.01 in adjusted EPS, down from $1.86 last year. This is primarily because OneMain is reserving more for potential loan losses, with provisions of $479 million, up from $338 million last year. While it has expanded into areas like auto loans, OneMain is primarily an unsecured lender to middle and working-class consumers. This leaves earnings quite exposed to the economic cycle. While its higher-risk lending profile means that its interest rates are quite lucrative when times are good, losses can be greater during periods of downturn, particularly as unsecured loans tend to recover less than those secured by physical assets like a car or house.

It is unsurprising to see loan provisions rise as the economic cycle continues to mature, and it is why I argue that, generally speaking, OMF is not the type of stock one would want to own heading into a recession, as its earnings will likely deteriorate significantly. As it is, we are seeing degradation occur, though the company is still quite profitable as interest income more than offsets rising provisions.

You may have seen headlines recently of credit card debt passing $1 trillion. It should be no surprise then to see that OMF’s loans outstanding (or “managed receivables”) are up 6% from last year to $21.4 billion. The average yield on its portfolio is 22.2%–as noted above because unsecured loans are riskier they offer quite impressive yields. This yield is actually slightly lower than last year’s 23.1%, as the company has tightened standards and shifted lending away from lower-credit consumers where charged interest rates are higher.

However, while fears of recession have abated, the economic outlook is clearly quite uncertain. Against this backdrop, I would like to see management tighten credit standards to guard against potential losses. That does appear to be happening, with originations running about 6% lower than last year. So while its portfolio has grown, its ongoing lending activity is starting to slow.

While OneMain is doing the right things by tightening credit standards, reserving for a downturn, and slowing originations, it cannot entirely manage away the cyclicality inherent in its business. Last quarter, net charge-offs rose by $102 million to $385 million. Because the company reserved $479 million for losses, its allowances for future loan losses rose by $94 million. In other words, management is preparing for loan losses to continue to rise.

Indeed, it has set aside $2.4 billion for loan losses, or 11.7% of its portfolio, up from 11% last year. While charge-offs have risen by 164bp over the past year, they are substantially below reserves at 7.6%. As you can see, OMF has been steadily building reserves against future losses. This reduces earnings today but prepares the balance sheet against a further macro deterioration. Again, I would emphasize that OMF’s management is acting prudently here.

If the Fed is able to achieve a soft landing, and we do not experience a recession over the next 12-18 months, OMF has likely reserved adequately for loan losses on its portfolio, and we may see it slow its ~$75 million quarterly reserve build seen over the past year. If reserving could slow in half, OMF has an underlying quarterly earnings run-rate of $1.3-$1.40, or about $5.50/year. With shares trading around $42, that is about an 8x earnings multiple.

Given the high cyclicality of its business which creates the potential for volatile earnings over time, OMF will structurally trade at a lower multiple than the broader market, and with many banks with more diversified business like Capital One (COF) and Citizens Financial (CFG) similarly trading with single-digit earnings multiples, I view 8x as about fair value for OMF.

To be clear, OMF is trading 8x earnings only when one assumes there is not a recession or further meaningful uptick in defaults. With the personal savings rate having fallen substantially, inflation continuing to squeeze real incomes, and higher interest rates still filtering through the real economy, there is a risk OMF sees more delinquencies and defaults, requiring it to reserve more.

If loan losses continued to rise as much over the next year as they have the past year, OMF would need to boost quarterly provisioning by at least $50 million to keep provisions from declining, meaning earnings would likely decline to about $0.60-$0.75 or about $2.50/year. At a 10x trough multiple, that results in downside to about $25, which is also roughly where book value sits.

Last October, I felt, risky as it was, OMF offered upside because it was trading closer to this book value floor. Today, the stock is trading close to its “no recession” level and well above its potential recessionary floor. If we were to assume there is a 1 in 3 chance of recession (i.e. it is not the base case but is a substantial risk), we get a fair value of about $38 for OMF, representing ~10% downside.

In order to justify a $42 share price, one would have to view the risk of recession as about a 10% probability, which when considering the US generally experiences a recession within every 5-10 years, would imply a lower-than-average risk of recession currently. That is possible, but it strikes me as an aggressive stance.

Investors who do not believe a recession is coming and are income sensitive can continue to hold OMF, recognizing there is limited upside from here but that they can collect a % dividend yield. Overall though, with shares pretty fully pricing in the no-recession scenario and with meaningful downside if there is one, I believe now is a prudent time to take profits in OMF and re-deploy into stocks with less economic sensitivity or those pricing in a higher probability of recession. If recession fears do resurface, there will be a time to buy back into OMF meaningfully below current levels.