After robust expansion in the past one decade, the leasing industry in China is entering a transition period, due to tightening of regulatory supervision and intensified competition in recent years despite penetration rates remaining low. However, we expect individual players with more diversified funding sources, prudent risk management and a sustainable growth strategy to sustain superior ROE with market share gains through the cycle and reiterate our positive views on both Chailease and FEH.

 The big picture: growth slowdown with increasing concentration. Finance lease contract balance in China has expanded by more than 60x in the past one decade but only represents low single-digits of total social financing (TSF) and implies leasing penetration rates of 8% compared to over 20% in developed economies. However, outstanding contract balance declined YoY in FY20 for the first time due to tightening of regulatory supervision and intensified competition; there is rising concentration in terms of market shares at leading players and growing focus on the urban utilities, infrastructure and transportation segments.

 Regulatory trend: tightening supervision to squeeze out irregular players. New regulations for foreign/local leasing companies have been laid out post the change of governing authorities in 2018, which in our view does not represent material tightening of business practices but the enforcement should gradually drive out companies with ‘abnormal operating conditions’. In the mid to long run, the key policy uncertainty remains potential downside on asset yields, given continued policy emphasis on reducing financing costs for the society as a whole.

 Differentiating factors: funding capability, risk management, growth strategy.

Leasing companies rely on whole-sale funding. Thus diversified funding sources are crucial to manage funding costs and facilitate balance sheet expansion. Large financing leasing companies enjoy funding advantages. Companies with prudent risk management mechanism would be able to manage down asset quality volatility and deliver better riskadjusted returns through the cycle; FEH and Chailease stand out among peers. In addition, foreign leasing and sub-tier-1 financial leasing companies have delivered stronger portfolio growth, given more diversified industry exposure and aggressive risk-taking.

 From financing to operating. In addition to operating lease, individual leasing companies like FEH and Chailease have penetrated industrial operations, such as hospitals and solar power plants by leveraging their industry professionalism, which may result in additional earnings uncertainty, due to increasing operational complexity, but such initiatives have been largely ROA-accretive so far, based on our estimates.

 OW on Chailease and FEH. We expect both Chailease and FEH to emerge from the COVID-19 downturn with double-digit earnings growth in FY21 on the back of improving portfolio growth and/or declining credit costs. ROE at Chailease is likely to reach a new high in FY22 while the spin-off and separate listing of operating lease unit at FEH could help to mitigate its fair value discounts.