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Morningstar | Tighter Credit and a Softening Housing Market Hurting Mortgage Choice. FVE Cut 12% to AUD 1.50. See Updated Analyst Note from 17 Dec 2018

As reported in our Dec. 13 note, Mortgage Choice reduced fiscal 2019 cash profit guidance by approximately 12% to AUD 14-15 million from previous guidance of about AUD 16.5 million. The mortgage broker blamed tighter lending standards and a slowing housing market for an approximate 10% decline in new home loan settlements compared with fiscal 2018.

We reduce our fiscal 2019 forecast loan settlement volumes by 12% to AUD 10.2 billion, reducing origination commission revenue by AUD 3 million to AUD 62 million. The changes result in a AUD 2.3 million, or 14% cut in our forecast cash profit to AUD 14.3 million from our previous forecast of AUD 16.6 million. We now forecast a 39% decrease in cash EPS for fiscal 2019, with average EPS for fiscal 2022-2023 declining to 1% per year from our previous forecast of 2% per year.

Our fair value estimate declines 12% to AUD 1.50 per share, and at a current price around AUD 1.10, the stock screens as undervalued, trading 27% below our valuation. If achieved, our fiscal 2019 cash profit forecast will be 39% lower than the AUD 23.4 million reported for fiscal 2018. Mortgage Choice releases first-half fiscal 2019 accounts on Feb. 21, 2019 and we expect a first-half cash profit around AUD 7 million, which is down 43% on the previous corresponding period, and a fully franked interim dividend around AUD 5.0 cents per share, down 42% on a year ago.

The lower forecast profit and a reduction in the payout ratio results in a lower forecast dividend for fiscal 2019 of AUD 10.50 cents per share from our previous forecast of AUD 13.0 cents per share. Our expected payout declines to 92% from 98%. The earnings downgrade disappointed, and the risk of further downgrades in fiscal 2020 remain as new home loan settlements could deteriorate further from the estimated 10% decline for fiscal 2019. One positive to emerge from tougher lender imposed underwriting standards is lengthening of average loan life.

The firm reported the first increase in average loan life for seven years to 4.1 years for fiscal 2018 and management confirm the lengthening trend continues. A longer average loan life is a relative positive for future trail commission income, as we expect trail commission to decline at a slower pace than upfront origination commission. In our fiscal 2019 forecasts, we see upfront origination commission income falling 11% compared with a 4% decline for trail commission. We now forecast trail commission revenue of AUD 94.5 million in fiscal 2019, down from AUD 98.5 million in fiscal 2018.

Significant uncertainty surrounds potential changes to future commission methodology with clarity not expected till 2019 following the Royal Commission final report due in early February and a potential change of government in May 2019. The Productivity Commission and the Australian Securities and Investments Commission are also involved, adding further complexity to the likely outcome. Despite potential changes, we expect broker usage across the industry to remain relatively high, with levels around 54%, due to increasing challenges of securing a home loan, complexity around terms and conditions and interest rates for owner-occupier, investment, and interest-only loans, and general high levels of customer satisfaction from the mortgage broker experience.

Potential outcomes are a flat origination commission paid by the lender or a higher variable origination commission rate and the removal of trail commission. We believe a flat upfront fee paid by borrowers is unlikely, as the likely consumer response would see a significant shift back to banks for home loan finance applications, reducing competition and likely increase mortgage costs for consumers. In this worst-case scenario, mortgage brokers, including Mortgage Choice, would likely suffer a material drop in new loan settlements and valuation. Mortgage Choice’s average origination and trail commission rates were 0.65% and 0.18%, respectively, for fiscal 2018.

Extensive cost-cutting and productivity improvements are insufficient to offset for the fall in revenue. Despite the disappointment of lower top line revenue, the firm maintains cost guidance for fiscal 2019, targeting a 10% cut in operating costs compared with the AUD 35 million incurred in fiscal 2018. The firm confirmed the new broker remuneration model was implemented in early August and by November 2018 and all franchisees had moved onto the new broker software platform.

Previous profit guidance of AUD 16.5 million was predicated on fiscal 2019 home loan settlements being 10% below the AUD 11.5 billion reported in fiscal 2018 and origination commission income broadly in line with the AUD 70 million reported in fiscal 2018.

Mortgage Choice will continue to face material industry headwinds in 2019 as mortgage brokers experience longer processing times for loan applications due to tightening lending policies. Home loan applicants are under more rigorous scrutiny, being required to supply more backup to verify income and living expense detail. Maximum borrowing capacity is being reduced and it is becoming tougher to secure higher loan to valuation ratio loans. As a slight and tentative positive, the latest housing finance data from the Australian Bureau of Statistics disclosed an increase in October figures compared with September 2018, both in terms of the number and value of housing finance commitments.

Despite an unexpected jump in October, the trend for total dwelling commitments remains downwards, with the value of dwelling finance declining 1.0% for the month. In seasonally adjusted terms, the value of total dwelling commitments bounced by 2.6% to AUD 30 billion for October from AUD 29.3 billion in September but was still 8.6% lower compared with October 2017. The value of investment lending finance approvals edged up by 0.6% during the month, though dropping 18% compared with October 2017. The value of owner-occupied mortgages was in a better position, rising 3.5% from September while down 3.2% on a year ago. Throughout October, 52,654 owner occupier home loans were approved, up from 51,520 in September, showing a 2.2% growth.