Rising Prime Mortgage Competition And Credit Normalization Will Pressure Margins And Future Earnings

Catalysts

About Pepper Money

Pepper Money is a diversified non bank lender providing mortgage, asset finance and loan servicing solutions across Australia and New Zealand.

What are the underlying business or industry changes driving this perspective?

• Accelerating shift toward prime, lower margin mortgages combined with an originate to retain posture may lock Pepper into structurally tighter pricing just as competition for high quality borrowers intensifies, constraining revenue growth even if volumes stay elevated.
• Heavy reliance on whole loan sales and securitization to recycle capital into new originations exposes the model to any future tightening in private credit and ABS demand. This could abruptly slow balance sheet expansion and pressure earnings.
• Rapid AUM growth alongside rising asset finance coverage ratios and still elevated arrears risks a credit normalization phase in the next downturn. This would force higher loan loss expenses and erode net margins from current levels.
• Continual investment in technology, AI and scaled platforms, while driving efficiency today, could see diminishing productivity gains relative to spending over time. This may limit further cost to income improvement and cap profit leverage to future growth.
• Record dividends, buybacks and debt repayments funded by strong cash generation and whole loan sale gains reduce balance sheet buffers just as the rate and macro cycle normalizes. This increases vulnerability of return on equity and earnings if funding costs or impairments turn adverse.

Assumptions

This narrative explores a more pessimistic perspective on Pepper Money compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts. How have these above catalysts been quantified?

• The bearish analysts are assuming Pepper Money's revenue will grow by 12.8% annually over the next 3 years.
• The bearish analysts assume that profit margins will shrink from 25.5% today to 21.4% in 3 years time.
• The bearish analysts expect earnings to reach A$119.5 million (and earnings per share of A$0.26) by about December 2028, up from A$99.1 million today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as A$153.4 million.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 9.8x on those 2028 earnings, which is the same as it is today today. This future PE is lower than the current PE for the AU Diversified Financial industry at 17.8x.
• The bearish analysts expect the number of shares outstanding to grow by 0.89% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 11.72%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• The return of growth in the Australian and New Zealand mortgage markets, supported by multiple RBA rate cuts, moderating inflation and improving consumer confidence, is already flowing through to 64% growth in mortgage applications and 53% growth in originations. This could underpin sustained revenue expansion rather than a prolonged decline in earnings.
• Pepper Money is demonstrating strong operating leverage from its scaled technology platforms and AI driven process automation, with productivity up as much as 109% in some settlement functions and the cost to income ratio improving to 51.7%. This could help protect net margins and earnings even if headline net interest margins face competitive pressure.
• Diversification across Mortgages, Asset Finance and capital light Loan and Other Servicing, including a rapidly growing servicing AUM base and 57% growth in servicing and other operating income, provides multiple earnings streams that may offset weakness in any single segment and support more resilient group level income and profit.
• Disciplined credit risk management, evidenced by arrears trending down or stabilizing, coverage ratios that remain in line with or above long term averages and a shift in Asset Finance originations toward low risk Tier A customers, could limit future loan loss expense and support stable net profit over the cycle.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Pepper Money is A$1.85, which represents up to two standard deviations below the consensus price target of A$2.21. This valuation is based on what can be assumed as the expectations of Pepper Money's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
  
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of A$2.7, and the most bearish reporting a price target of just A$1.85.
  
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2028, revenues will be A$557.6 million, earnings will come to A$119.5 million, and it would be trading on a PE ratio of 9.8x, assuming you use a discount rate of 11.7%.
  
• Given the current share price of A$2.18, the analyst price target of A$1.85 is 17.8% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
  
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.