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Date : 29/05/2023

Australian Finance Group

ASX :

AFG

Market Cap : $427 million

Dividend Per Share : $0.16

Dividend Yield : 10.32 %

Buy

52 Week Range : $1.350 - $2.060

Share Price : $1.57

AFG has solid long-term growth and pays an impressive 15% gross dividend. We think they're well placed to ride out headwinds from rising rates. We recommend a 'Buy'

Company Analysis

Australian Finance Group Ltd (ASX: AFG), headquartered in Perth, is a long-term stable presence in the Australian lending landscape. The company was launched in 1994 and has been ASX listed since 2015. AFG has a market cap of $427 million and is trading at close to half of its peak valuation achieved during the Covid pandemic.

The company offers residential and commercial mortgages, equipment and asset finance and personal loans. There are over 3,700 brokers on the books, supplying loans from over 70 different lenders. Essentially AFG takes a cut of every loan they secure.

The company is on a solid long-term growth trajectory. The following chart shows AFG quarterly residential mortgages lodged. They’ve grown from $8.32 billion to 19.41 billion in 10 years.


Source: Shares in Value / AFG Mortgage Index Q3 2023

The record low-interest rates during the pandemic were a boost to home lending. The quarterly peak during the pandemic was $24.6 billion. Now we’re seeing fewer mortgages lodged as rates normalise, although volumes are still well above pre-pandemic levels.

To us, this softening looks natural and expected. Nothing suggests that the company is not still on their long-term growth path. However, the market is punishing the stock price severely. This creates a great opportunity to get into this high-quality company. This is more than just a growth story. It’s also a great dividend play, which we’ll dig into further on.

Residential mortgages – The Main Game

Aggregation

On the surface, AFG is an Aussie housing market play. An alternative to the banks. The following snapshot of the business comes from the Half Year 2023 Results Presentation.

Source: AFG Half Year 2023 Results Presentation

It’s pretty clear that residential mortgages are the main game for AFG – with a loan book of $189 billion. AFG sources 10% of all residential mortgages in Australia. So they have a strong presence in the market, touching a significant portion of all loans written. This gives them a lot of data and insight into the residential property market. More importantly, they take a percentage of each home loan they facilitate.

It’s still a relatively small company at less than half a billion dollar market cap. Yet the number of loans they handle rivals National Australia Bank Limited (ASX:NAB). A strong driver of AFG’s growth has been the rise of the mortgage broker market share. Currently, 72% of home loans are sourced by brokers. In 2017 that number was 53.6%.

AFG is at a very exciting point in its journey. They have gained substantial influence on the residential mortgage landscape, and yet they still have room to grow within the market.

But connecting customers with lenders isn’t the only growth opportunity.

AFG Home loans

AFG is growing strongly as an actual lender. So not only are they working with the banks to get them clients, but they’re competing with them as well.

This is a much smaller part of the business but brings with it higher margins. The company raises capital through Residential Mortgage Backed Securities (RMBS). The securities stand at about $5 billion but are increasing in size and frequency. The following chart shows the history of their RMBS issuances.


Source: AFG Half Year 2023 Results Presentation

They’re the biggest non-bank lender and 6th in market share in the home loan market. As interest rates have risen, there’s been strong competition from the banks to secure the shrinking number of new loans being written. This puts them at a short-term disadvantage, but they see a return to growth in the next 6 to 18 months.

This part of the business is really the up-sell. It’s a higher-margin add-on that can be offered to expand profitability. Because AFG has such a strong aggregation business, they have the luxury of being disciplined and patient and not having to compete so hard in this segment.

Securities contributed 4% to gross profit in FY2015. In FY2022, it had risen to 26%. Keep in mind they’re still dealing with relatively small volumes compared to the aggregation business. When competition eases in the mortgage sector, lending has big profit-boosting potential. AFG has the potential to transition into a major lending player, which could lift the business to a whole new level of profitability.

Growth opportunities

AFG are targeting commercial mortgages and asset finance as two growth areas. The commercial mortgage loan book stands at $11 billion at the end of the December 2022 quarter. Asset finance settlements were $1.2 billion.

The commercial side of the business had a big year in FY2022, posting settlements up 67% to $3.9 billion and end-of-year loan book at $10.9 billion, up 19%. While the residential side of the business slowed in early FY2023, the commercial side has been more stable. The loan book lifted 2% for the first half of the fiscal year.

By the company’s estimates, they have just 2% of the market share in the combined commercial lending space. Broker share of the market stands at 20-30%, less than half of the penetration of residential.

There’s a large gap here between the current state of things and the potential. This is a large focus for the company at the moment. They have an extensive broker network and the tools and systems in place. This can all be leveraged for low-cost gains in the commercial space, which is a very attractive opportunity.

The recent growth in the commercial side of the business is no accident. It’s been another core focus of the company. In particular, it’s been fuelled by some recent acquisitions.

Acquisitions

How many times have we seen a company with big acquisition plays, only to be followed by big right downs? There are just so many hurdles to a successful acquisition.

Identifying a target that brings a real – and not imagined – benefit is a challenge in itself. Add to that the complexity of successfully integrating another business to reap the benefit of all those “synergies”. Then grow the business to meet all those highly optimistic targets. Takeovers are no easy task. It’s rare to find a company that can do them really well, especially in the small-cap space. And AFG is certainly a small cap.

So it won’t surprise you to hear that their recent acquisitions have had a bumpy ride. The only problem is that’s not the case. AFG actually seem to be really good at acquisitions. Good at target identification, getting the deal, integration and, most crucially – growing the new member of the family.

The following table shows their three recent acquisitions. Now, they don’t own any of them 100%, but they do have a controlling stake in two of them.


Source: AFG Half Year 2023 Results Presentation

These acquisitions show a thoughtful approach by management. They are all focused on the growth areas that the business is targeting.

The Thinktank stake was completed in 2018 for $10.9 million in cash. They already value the investment at $31.8 million. That’s a return of almost 24%. This has been a truly synergistic purchase. It’s allowed AFG to offer their white-label commercial mortgage product through the Thinktank broker network and also allowed Thinktank to leverage AFG’s strong existing network.

The two more recent additions have also grown strongly in a short period of time. These might be too new to call a roaring success straight away. But they certainly fit with AFG’s strategic plans, and they’ve shown they have the ability to extract value from their takeovers. So we’re optimistic about their potential to add an extra level of growth to the AFG story.

Fintelligence is similar to the Thinktank purchase in that it gives AFG instant access to an asset finance brokerage network. The company comes with its own proprietary technology platform. AFG is seeing the benefit of “…growing in-house referral service for AFG’s residential brokers and a direct to-consumer web presence.” So again, strong synergies are being realised, which might not be apparent in the surface metrics.

BrokerEngine offer workflow management software for mortgage brokers. It will connect into AFG’s existing platform. This will give AFG access to the BrokerEngine network, allowing more cross-selling and marketing opportunities. On top of that, the number of subscribers has nearly doubled in the 18 months since the acquisition.

So clearly, they’re using these purchases to buy market access, but they’re also coming with a strong technological edge.

Investment Thesis

The market is notably pessimistic on AFG’s future. With a share price of roughly half its peak two years ago, it speaks of something seriously wrong in the business. But the thing is, there really isn’t.

Interest rates are rising quickly, and that is dampening residential housing growth. There’s no denying that. But it’s really not as dire as it looks on the surface.

For one, the company has a stellar growth record through periods of rising interest rates. The following chart shows their lodgement volume and the overnight cash rate during the last hiking cycle.


Source: AFG Half Year 2023 Results Presentation

There were periods of high volatility, but there’s an undeniably persistent growth. The current hiking path has been much quicker, and it may still continue for some time.

However, rates will only climb if inflation stays high and unemployment low. Inflation is a great hedge for AFG. It puts upward pressure on house prices and, therefore, loan values.

The company also has plenty of room to grow market share in all areas. In particular as a lender and in the commercial side of the business. These opportunities areas remain a focus, and they’re seeing good results for the hard work.

The Trailbook

AFG doesn’t just receive a signing bonus as a mortgage broker. They have a trailbook that pays a residual commission for years after the mortgage is signed. For their aggregation business, the trail commission accounts for 60% of revenue. So most of the money they make comes in the years after they sign a mortgage.

The great thing about this model is that it softens market downturn impacts to the company’s revenue and profit. So they get a more consistent income.

The proportions are even more favourable when they write the loans themselves. In this case, the company is acting as the lender and continuing to collect the difference between their funding costs and lending rates for the entire life of the loan. It’s easy to see why this makes the lending side of the business so attractive, and how it’s managed to achieve such out-sized contributions to gross profit.

The following charts show the commission earned for the aggregation business on the left and lending on the right. The dark blue is the trailing commissions, which are dramatically larger for the lending side.


Source: Half Year 2023 Results Presentations

Dividends

While there’s plenty of reason to believe AFG can continue to grow, this is also a great dividend payer. And while there’s nothing wrong with their long-term growth story, it’s the current dividend yield and valuation that really gets us interested.

This is a great addition to a dividend portfolio. Trailing 12-month dividend yield is 10.5% (at a $1.54 share price). The company pays a fully franked dividend. So grossed up, that comes to 15%. The following chart shows the dividend yield history. Other than a short-term spike during the pandemic, there haven’t been many opportunities to pick up AFG at this dividend yield.

AFG Dividend Yield (Source: Finbox)

Anytime you find a quality and durable growth business with such a high dividend yield, it’s worth paying attention. Dividend growth has been strong in recent years, with FY2022 dividends up 25% on the prior year.

AFG is a high margin business with low capital costs. This allows them to return much of their earnings to shareholders. We expect that dividends won’t experience the same level of growth for the next couple of years. They might even come down a bit. However, if we take a longer-term view of 5-years+, we see continued sustained dividend growth.

With inflation at 7%, it’s hard to find investments that will see a short-term positive real-return.

Growth is out. Cash is king.

Any dividend above 7% becomes appealing. A grossed up dividend that’s double inflation gives a lot of room for inflation to continue to rise, or the company’s dividends to fall, before it even looks like an average investment, let alone a bad one.


AFG Revenue and Market Cap (Source: Finbox)

As another way of highlighting how cheap the company is right now, the below chart shows AFG’s revenue in blue, while market cap is in purple. For the last 10 years, the company has rarely looked so cheap compared to revenue. Not to mention how good that revenue trajectory looks.

Recommendation

We recommend buying AFG at current prices, up to $2.31. This target price represents a current net dividend yield of 7%. Grossed up yield is 10%. At the current price of $1.54, it presents a 15% grossed up yield.

The business will have headwinds as long as interest rates continue to rise and property sales are subdued. However, this is a very strong business with proven growth through similar challenging environments. The negative sentiment is priced-in and we therefore think this is a good entry point.

AFG has a record of strong dividend payments. Even a 50% reduction in dividend payments for the next few years would be a sound investment at current prices. But we don’t expect a reduction anywhere near those levels.

The next few weeks could provide a great opportunity to load up on AFG if you’re not already in. The following chart shows the weekly price bars.

Technical Analysis

Source: TradingView

A downtrend started in late 2021, which ended with a capitulation in July 2022, where weak hands were flushed out in an accelerated move out of the general trend bounds.

Price has been sideways since and trades back within the consolidation range of the capitulation, which is shown by the two blue lines extending from the blue box. Usually, for a capitulation to be meaningful, price would be supported above the high of the consolidation, which has failed to happen this time.

However, we know this is where a lot of weak hands exited the positions, and price has been stable since. So it’s not a disaster.

If we look back to the Covid capitulation, we can see consolidation in the orange box. Price was supported above this area. We’ve just now re-entered the same consolidation range.

There should be strong buying within this range. Anyone who was paying attention during the Covid capitulation knows how good these prices are and how long it’s taken to get back down there. Buying within this $1.235 to $1.595 range presents excellent value.

A break back above the long term-level at $1.725 would be strongly bullish.

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