EUR 850.00 For Business Accounts Only

Morningstar | Mortgage Choice Resets and Moves on Despite Increasing Industry Headwinds. FVE of AUD 1.70 Unchanged

No-moat-rated broker, Mortgage Choice is at the cross roads and has reset the business model to cope with a rapidly changing operating environment. The pre-released AUD 23.4 million fiscal 2018 cash NPAT increased 3% on fiscal 2017 and was driven by a 1.5% increase in net commission income to AUD 60 million and a 1.4% decline in operational expenses to AUD 35 million. The finally fully franked dividend of AUD 9 cents per share took total dividends to AUD 18 cents per share, 3% higher than a year ago based on a 96% payout. Our fair value is unchanged at AUD 1.70 and the stock is trading broadly in line with our valuation.

Following the result, we maintain our fiscal 2019 cash NPAT forecast of AUD 16.6 million and full-year dividend of AUD 13 cents per share, underpinned by the newly introduced franchise payout and reduced operating expenses, broadly in line with profit guidance. We continue to forecast a subdued medium-term outlook for Mortgage Choice and expect no growth in EPS in fiscal 2020 and fiscal 2021, before some modest improvement in fiscal 2022 and fiscal 2023 on the back a stabilisation in the new lending volumes and increased contribution from trail commission as average loan lengthens.

The mortgage broking industry has been hit with a wide range of regulatory, government and independent inquiries as well as the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services industry. Future changes to industry structure will impact the broker's earnings and valuation, but at this stage, uncertainty prevails. We expect some industry clarity by mid- to late-2019 following the government response to any recommendations made by the Royal Commission. The Commission's final report is due to the government in February 2019.

Despite the far-reaching negative publicity aimed at banks and mortgage brokers, consumer demand for mortgage brokers continues to grow with industry statistics pointing to an increasing broker market share with a record-high 55.3% of home loans originated in the March quarter 2018 were done via a mortgage broker. Increasing loan complexity and tougher lending standards are driving more and more borrowers to the services of mortgage brokers.

The four major banks, excluding Commonwealth Bank brand Bankwest and Westpac Bank brand St. George, continue to lose market share accounting for only 42% of Mortgage Choice originated home loans in fiscal 2018, down from 51% in fiscal 2016, and close to 70% a decade ago. Mortgage Choice is originating an increasing share of smaller bank residential mortgages, up to 34% in fiscal 2018 from 30% in fiscal 2016 and nonbank lenders doubling to 11% in fiscal 2018 from 6% in fiscal 2016, albeit off a small base.

A key takeaway from the result was the first increase in average loan life for the past seven years as a weaker housing market and tighter lending standards reduced loan churn. While early days, this development is a positive for brokers like Mortgage Choice and all mortgage lenders and partially offsets the slowdown in new lending volumes. We expect Mortgage Choice upfront commissions received to decline by about AUD 3-4 million each year for fiscal 2019 and fiscal 2020, but we forecast trail commissions to increase marginally each year for the same period. The average loan life of existing loans increased to 4.1 years in fiscal 2018 from 3.9 years in fiscal 2017 and the average loan life of new loans increased to 4.9 years in fiscal 2018 from 4.6 years in fiscal 2017. The 6% reduction in the loan run off rate assumption resulted in a positive non-cash after tax adjustment of AUD 7.1 million to trail commission income receivable in the balance sheet.

New loan settlements of AUD 11.5 billion in fiscal 2018 were 7% lower than fiscal 2017 due to the softer lending market and a decline in Mortgage Choice's market share of approvals to 3.4% at June 30, 2018 from 3.6% a year previously. The mortgage broker has experienced a slow and steady decline in market share from 4.2% at June 30, 2012. Despite the decline in new loan settlements the average loan book grew 3% year on year to AUD 53.61 billion. The major overhaul of the broker remuneration model is designed to reverse the decline in mortgage broker numbers by retaining brokers and attracting new brokers to the firm's franchise model. The franchise network remains stagnant at 449 over the past year, but individual licences mortgage broker numbers declined to 619 at June 30, 2018 from 654 a year earlier. A clear positive sign is the 80% of franchisees having opted-in to new remuneration model and the firm expects all will opt-in by the end of fiscal 2019.

The core mortgage broking business reported cash profits of AUD 22.75 million in fiscal 2018 up 4% on fiscal 2017, representing 97% of group. The mortgage broking business was complemented by strong profit growth of 7.5% in the smaller financial planning division to AUD 383,000. Despite the small contribution to group earnings, the 38% increase in funds under advice and 15% increase in insurance premiums in force impressed. We like the diversification strategy but acknowledge it will take several years to generate a meaningful profit contribution.