This is not investment advice. Do your own research before taking a position in any of the securities mentioned in the post below.
Context before the valuation
Before I launch into my valuation of LFG, I wanted to highlight a few factors
Lenders with high leverage over-earn in good times and under-earn in bad. As such, it is not unreasonable to expect that the downside risk for LFG can be substantial
LFG is trading at c.10x P/E due to "over-earning" and lack of liquidity. I think it is reasonable to assume earnings fall in the short-term but long-term P/E widens to 15x
This is supported by 4x sell-side brokers (CS, BAML, Macq & Citi) covering LFG all with "Strong Buy" recommendations.
I would take that with a grain of salt because it is a recently listed business & chances are all those brokers want cap raising fees if they do any share raisings
A bit over a month ago, LFG reported FY21 results
By growing their market share of commercial/SME book, LFG has overcome a slowdown in non-Big 4 residential lending
When compared to Big 4 - LFG has quicker processing times but worse fixed-rate loans (due to RBA facility). The real bull case scenario is if Big-4 share decreases like it was pre-COVID-19, then LFG can grow its prime book without increasing its riskier types of loans
Historical performance - Take the 2021 performance with a grain of salt
A few things that immediately come to mind when you look at the financials of LFG are
Huge loan growth between 2019 & 2020 = low loan growth in 2021
Being very blunt; revenue is about 7-7.5% of average loan book
NIM impacts their financials more than loan growth alone
BDD in 2021 were abnormally low, this means more BDD losses are to be expected in future
Whilst LFG management like to adjust NPAT for a $12m amort charge; I disregard it because the market does not value it
This is set out below
Forecast performance - I think earnings will drop by there is a buffer in the low market multiple for LFG
Overall, I think the market multiple on LFG at 10x is due to a lack of liquidity. Assuming a dilutive acquisition or stock split, I do expect float/liquidity in the stock to improve simply because it will result in a more favourable valuation which management will support
Using historical levels it is best to model your valuation off;
NIM = 2.5%
BDD = 0.35% to 0.45%
Loan growth = 7% to10% (noting NIM is a bigger driver).
As a general rule, this should mean NPAT margins of 12% and cost-to-income ratio of 20-22%
So as set out above - I think the risk of NIM compression & higher BDD is likely to be offset by higher trading multiple (closer to 15x). Right now the market does not trust the FY21 BDD of nil vs. historical 0.3%; so even when BDD returns the valuation should not contract matierally
Also, although it is a smaller driver, I think the upside for LFG is that lending growth is likely to remain strong because
the SMSF product is particularly popular
self-employed people or those in certain industries have already been subject to more stringent restrictions on access to finance even prior to the income shock that occurred during the pandemic; these are likely to go to LFG on low LVRs
Risk offsetting this optimism are SME default rates/funding conditions/default rates
SME lending concerns after JobKeeper roll off; whilst I do think LFG's book is much more exposed to residential/commercial real estate - a shock in SME business conditions would be detrimental
Worse funding terms: LFG has really leant in on great wholesale and note markets. This being said, Macquarie asserts that attractive market conditions could extend further into FY22 if bank bill swap rates remain lower for longer.
Tail risk: Overall LFG has reduced its non-conforming exposure but as covered in the first article, the higher the amount of NC - the bigger the default risk in a downturn
So in conclusion, LFG is over-earning in CY21 and the stock is highly illiquid. That being said, I think even an increase in BDD and lift in funding costs (i.e. lower NIM) could still mean an investor has a margin of safety if you assume the market is willing to pay a 15x multiple for this company in the long term. The only way this will happen is liquidity (e.g. free float) increases.
Given the low trailing multiple, management is encouraged to take actions to increase liquidity to ensure the stock re-rates. In the meantime it is likely (but not impossible) that NIM remains high (2.7% to 3%) and even if BDD increases there is a margin of safety at a 10-11x multiple. Perversely, I think a path to further stock liquidity is dilutionary M&A (e.g. Westpac autos deal) and in this instance, I think the stock will benefit from the higher free float.
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