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Morningstar | Mortgage Choice 1H19 Profit Down Sharply, but Better Than Expected. FVE AUD 1.10 Unchanged

No-moat-rated Mortgage Choice is battling challenges on multiple fronts with first half cash profit down 43% from the previous corresponding period, or pcp, to just AUD 7.1 million. Despite overwhelming negativity, the result was better than expected and we are modestly more confident in the long-term outlook for the embattled mortgage broker. Management is doing everything it can to deal with the challenges and continues to set the business for an eventual upturn in mortgage growth and resolution of structural industry changes. But it will take 12-18 months before industry, political and regulatory issues settle, and the business can start growing again. Despite a solid 10% rebound in the stock price on the day of first-half earnings release, it is trading 27% below our AUD 1.10 per share fair value estimate.

The stock price has been under considerable pressure during the previous 12 months due to the firm’s broker remuneration model changes, a weaker property market, tougher lending standards, and the not inconsiderable fallout from the Royal Commission. Statutory NPAT for the half of AUD 6.4 billion declined 44% on the pcp.

The better-than-expected first-half profit prompts an increase in our full-year cash NPAT forecast to AUD 14.1 million, up from our previous forecast of AUD 12.9 million, and toward the bottom of the AUD 14 million to AUD 15 million guidance range. The cut in interim fully franked divided to AUD 3.0 cents per share, or cps, surprised and was well below the AUD 4.50 cps we expected. The interim payout was cut to 53% from previous interim levels of 90%. Despite the profit uplift, we cut our forecast fiscal 2019 dividend to AUD 6.5 cps from our previous forecast of AUD 9.50 cps based on a revised 55% payout (previously 93%).

As expected, the franchisee remuneration model implemented in August 2018 caused a material shift in the allocation of net revenue with franchisees receiving a greater share of the pie.

The upside from the new remuneration model is a stronger and more sustainable business model, but all the good work has been substantially undone by significant challenges brought about by the Royal Commission recommendations and the consequent government response. The Royal Commission recommendations, if adopted in full by the government, would likely see the mortgage broking industry decimated, but it now appears both political parties have a more sensible position on broker remuneration, backing away from the Draconian Royal Commission recommendation to force brokers to charge borrowers upfront fees replacing the current structure of lenders paying the brokers.

The potential damage to the industry is ironic as mortgage brokers originated 59% of all home loans in the September 2018 quarter based on Mortgage and Finance Association of Australia’s quarterly survey. The "Value of Mortgage Broking" report published July 2018 carried out by Deloitte find 90% of broker customers are satisfied with the service and the Net Promoter Score from customers of mortgage brokers is in excess of 70%.
Cash operating expenses fell 6% on the pcp and are on track meet the full-year target for a decline of 10% in cash operating expenses for fiscal 2019.

The sharp fall in first half profit is partly due to weaker demand for residential loan finance, a softer property market and tougher lending underwriting standards. A minor positive is despite a 15% fall in loan approval values and 12% decline in settlement values, the firm’s total loan book increased 1% on pcp to AUD 54.5 billion as at December 2018. In the half, a higher average loan life offset the lower settlement volumes, but if the trend continues for softer settlement volumes, the loan book will start to shrink.

The small but fast growing financial planning business continues to impress and we like the diversification provided. Funds under advice increased 29% on pcp to AUD 817 million and insurance premiums in force increased 9% to AUD 29 million. Despite the strong flow performance cash NPAT is small at just AUD 35,000 for the half compared with AUD 7.1 million for the core mortgage broking business.

The new broker remuneration model resulted in a net payout of 74% of commission revenue to franchisees from the previous model of approximately 65%. The expected payout under the new model is 73%. Average commission rates were broadly stable in the half with the upfront commission rate of 0.6554% and the average trail commission rate of 0.1842%. Changes to the broker remuneration model and the one off impact of merging owners of multiple franchises resulted in a sharp decline in franchisees to 403 at December 2018 from 449 at June 2018. Not surprisingly, new franchisee recruitment is difficult in the post Royal commission environment.

Balance sheet settings are sound, with net assets of AUD 82.7 million, AUD 4.0 million in debt and the reduced dividend payout to 53% will add to cash reserves. Despite net operating cashflow of AUD 6.7 million in the half, the AUD 11.3 million payment of the fiscal 2018 final dividend drained cash, necessitating a new AUD 4.0 million debt facility. Lower earnings and increased Royal Commission uncertainty forced a substantial cut in the fiscal 2019 interim dividend payout to 53%.