The New Criterion: is there value in Mortgage Choice?

With Mortgage Choice joining the casualty list of high-profile franchised operations, investors are pondering just how low the mortgage broker’s shares can go following reports of a looming franchisee revolt.

The experience of franchise floperoo Retail Food Group, which has lost more than 80 percent of its value since early December, is hardly encouraging.

But there’s comfort of sorts for Mortgage Choice holders: according to Macquarie Equities, the value of the company’s cash and up-front and trail commissions already earned is worth $1.09 a share.

In other words, at these levels the market would be valuing Mortgage Choice’s franchise network and ongoing business at a big fat zero.

Even before last week’s revelations of a revolt among a large rump of Mortgage Choice franchisees, the mortgage broking sector faced stiffening headwinds with the prospect of tighter regulation and the onset of a housing downturn.

Even before that, investors had marked down Mortgage Choice shares after the banking royal commission created unfavourable headlines in March.

And let’s not forget that Mortgage Choice John Flavell departed suddenly in early April and without explanation, leaving CFO-turned-CEO Susan Mitchell to face what the French would politely call a sandwich du merde.

The immediate outlook for Mortgage Choice is not pretty, even though management scurried to change the commission structure to give discontented franchises a greater share of the spoils.

But if half the franchise base proceeds with a mooted legal action, the repercussions will soon bite the bottom line.

The broader question is whether the whole sector faces an existential threat because of dubious practices such as loan churning and lax customer vetting.

At the royal commission, the lightning rod for fury centred on the conduct of another major participant, Aussie Home Loans.

Rather than saving people from the banks these days, Aussie is fully owned by the Commonwealth Bank of Australia, in relation to dealing with a fraudulent broker.

Among the lowlights aired, an internal CBA report also admitted deficient oversight of broker loans in relation to misconduct and misselling.

Such revelations have prompted the mortgage brokers’ ultimate customers – the banks – to make ominous noises about curtailing the brokers’ commissions or pushing for a fee-for-service model.

The overwhelmingly majority of brokers don’t charge the borrower, but reap an up-front and trail commission from the bank (these average 0.65 percent and 0.15 percent of the value of the loan respectively).

The truth is the bank-broker relationship is symbiotic: regional banks without a bank network rely heavily on them and any bank failing to nurture this third-party network has quickly found their mortgage market share decreasing.

Mortgage brokers account for 55 per cent of all home loan originations and according to the relevant industry body that share has crept up 1.7 per cent over the past year.

In the past, the banks have tried plenty of times to curtail these payments. The Bank of Queensland even stopped using brokers for a period in the noughties.

The broker commission model means that brokers indeed have every incentive to recommend loans from the lender offering the best cut and up selling the value of these loans.

But a bank loans officer subject to aggressive performance targets can equally be guilty of writing bad business.

It’s likely the royal commission – as well as an ongoing Productivity Commission inquiry – will result in tighter regulation. One prospect is capped commissions similar to the life insurance industry.

But given the entrenched role of brokers in the $1.7 trillion mortgage market your columnist can’t see them being driven into the Red Sea. But they’ll get a bit wet.

The industry cites a separate ASIC review of broker remuneration, which concluded the broker model wasn’t broken but needed some tweaks. Whether these tweaks turn out to be an adjustment of the carburettor settings or a full engine rebore remains to be seen.

Arguably there are too many brokers – about 7000 active ones – and a housing downturn will hurt volumes. But rising rates will prompt existing borrowers to refinance and brokers love churn.

Based on expectations of flat full-year cash earnings of around $23m, Mortgage Choice trades on a current-year multiple of under eight times and a fully-franked yield of more than 10 percent.

However any investor who has been around for more than two seconds will know that such low multiples and high yields are usually illusionary.

Australian Finance Group (AFG) $1.34

At the time of writing, AFG shares looked to be suffering contagion from Mortgage Choice’s woes, although AFG CEO David Bailey offers other reasons for the sell-off.

“There’s a lot of uncertainty around the sector because of the royal commission and discussions about (broker) remuneration,” he says.

“Certainly Mortgage Choice is the big brand name while we’re more like a wholesaler.”

But while both stocks are mortgage brokers their business models differ markedly and Bailey has been on the investor hustings to drive the point home.

While Mortgage Choice is a franchisor – franchisees pay a buy-in amount for a designated patch – AFG is more of a support act for independent brokers.

Under AFG’s agglomerator model, brokers sign up for support services such as technology and (If they choose) the right to use AFG’s credit licence.

AFG charges a monthly fee for the services ($70 for the technology support, for example) and takes a modest cut of the broker commissions (about 7 percent of the upfront component).

AFG also has the primary relationship with the lenders via its lending panel. But in effect the brokers remain independent, operate under their own name and chase their own leads.

“In reality we give the brokers the tools to start a business,” says CEO David Bailey. “That can be anything from mums and dads in Parramatta to larger organisations like iSelect or Oxygen Group (part of the McGrath real estate group).”

AFG is also more diversified than Mortgage Choice, having entered home and small business lending in its own right.

AFG has also expanded its wares further by paying $10.9m for one-third of Thinktank, a mortgage-backed lender specialising in commercial loans.

The idea is that Thinktank sells the loans through its 2900 strong broker network.

With 2900 brokers on its books, AFG represents about half the broking industry. But AFG’s broking activities accounted for 60 percent of half-year earnings and this component should decline over time as the company builds its own-branded products.

AFG trades on a measly multiple nine times earnings and yields about 9 per cent. Notwithstanding a lending apocalypse, its business looks more robust than Mortgage Choice’s.

Tim Boreham authors The New Criterion

Disclaimer: The companies covered in this article (unless disclosed) are not current clients of Independent Investment Research (IIR). Under no circumstances have there been any inducements or like made by the company mentioned to either IIR or the author. The views here are independent and have no nexus to IIR’s core research offering. The views here are not recommendations and should not be considered as general advice in terms of stock recommendations in the ordinary sense.