Australian Finance Group (ASX: AFG) has a market cap of $419 million and is one of the largest aggregators in Australia, with over 4000 brokers. Australian Finance Group makes money from its brokers who pay around 10% of their upfront and 15% of their trail commission to Australian Finance Group on any home loans they arrange for clients. 74% of all mortgages in Australia are arranged through a mortgage broker. But getting started and operating as a mortgage broker is not easy.
This is where mortgage broker aggregators come in. Brokers sign up with the aggregator and get access to a range of different lenders. An aggregator accredits the broker under its licence, and helps them run their business, providing software and services to manage operations, including compliance, commission payments, marketing, and client management. In return, the broker usually pays the aggregator a percentage of their upfront and trailing commission.
As you would expect, it is in the best interest of the aggregator to ensure a broker is successful and compliant.
Australian Finance Group also provides home loans, funded by Residential Mortgage Backed Securities (RMBS), and makes money from fees for services and on the difference between the funding rate and the loan rate. This is called the Net Interest Margin (NIM).
The share price is currently down on lower profits in the last couple of years as competition and higher funding costs squeeze margins, but green shoots are appearing.
Why Did Australian Finance Group (ASX: AFG) Profits Go Down?
Australian Finance Group has suffered lower profits in the last two years. This is mainly due to the sharp increase in the cash rate affecting the net interest margin and the banks having an advantage with the Term Funding Facility (TFF), which provided the banks with cheaper government funding in response to the pandemic.
In FY24, total revenue was up 7% to $1.07 billion, with the distribution segment contributing 82% of revenue and the loan manufacturing segment accounting for 18% of revenue. Net Profit after Tax (NPAT) over the year was $29 million (22.3% lower than FY23).
Free Cash Flow (FCF) was $38.34 million, which is calculated by taking net cash flow from operations of $38.77 million minus expenditure on property, plant, and equipment of $473,000. If you are taking acquisitions ($10.24 million) and associated intangibles ($17.4 million) into account, then FCF comes in at $10.69 million. However, Australian Finance Group won’t always be acquiring companies.
While the loan manufacturing segment suffered a 35% drop in net income in FY24, the second half of the financial year saw improvement as competition pressures eased, while the Distribution segment climbed on broker recruitment and broker service fee income. Residential settlements grew 3% over the year, as cash rates settled in the second half.
Australian Finance Group’s balance sheet is strong with cash and investments at 30 June 2024 of $190.2 million with no debt. AFG funds many of its loans through off-book non-recourse Residential Mortgage Backed Securities (RMBS). These are securitised assets packaged and sold to institutional investors. Investor appetite was strong for the latest RMBS issue in July 2024. The fact that Australian Finance Group has a high-quality loan book with very few recorded arrears would help when finding investors to buy the RMBS products.
Australian Finance Group has lobbied the Australian government, receiving bipartisan support for a public Residential Mortgage Backed Securities (RMBS) scheme. My understanding is that the government is now undertaking an evaluation of the recommendation.
Australian Finance Group is potentially positioned to benefit from the termination of the Term Funding Facility (TFF). This was established by the Reserve Bank of Australia as part of its policy response to the effects of the pandemic, offering very low-cost three-year fixed-rate funding to banks operating in Australia. These facilities were paid back in June 2024, and arguably, this means that non-bank lenders are on a more even playing field with the banks again.
As you can see below, the market share of home loans written by non-bank lenders has recovered over the last two years.
Some Thoughts On The Mortgage Broking Industry
I recently had coffee with a friend who is a mortgage broker to get more insights on the industry.
While there can be a perception that some brokers may just put clients into mortgages with the highest commission, that is generally not the case, especially in smaller towns where doing right by the client ensures survival for the many small brokerage firms. Mortgage brokers also know a lot of things that someone just doing it themselves would not know or be able to search via the internet.
For example, brokers would know which banks are more or less receptive to people having flatmates, or which banks have higher limits for living expenses. Some banks may not lend for houses with monolithic cladding (Monolithic cladding, or plaster, has become almost synonymous with risky home purchases in NZ), by way of example.
Brokers often have an advantage over banks in that many can easily service more clients themselves and/or hire more people to service more clients. Anyone who has worked at a large bank (or any large corporation) will know that simply hiring more people to service more loan inquiries is not as simple as that. By the time the new employee makes his or her way through HR, fulfills the various checks, and is taught all the bank processes, the big bank has spent considerably more on the simple act of hiring one person than a small broker would have.
Mortgage brokers can be good for banks as banks are outsourcing much of the work and taking on responsibility for the clients, while the bank still makes money from any loans with the bank arranged by a broker.
Clients are often a bit nervous about making such a huge financial decision so talking to an expert is the logical choice for many. Despite advances in online advice, I think mortgage brokers will still be the preferred choice for many. I notice many financial platforms aimed at Millennials and Gen Z, still advise house buyers to see a broker. And, of course many savvy brokers are tailoring their businesses to the next generation of home buyers.
Risks for Australian Finance Group (ASX: AFG)
The big risk that I think may put investors off is the spectre of regulatory changes to broker commissions. i.e. the government abolishes commissions on the grounds they create conflicts of interest.
Opponents of a commission structure argue that brokers may be inclined to put people in the home loan that pays the broker a higher commission or refinance unnecessarily to another provider offering a higher commission. There is no doubt incentives can create conflicts of interest in some instances. After the Hayne Royal Commission into the financial services industry in Australia from 2017-2019 the Morrison government looked to abolish broker commissions. As expected, this was met with heavy lobbying by the mortgage brokering industry.
The mortgage broking industry donates to political parties, which means abolishing broker commissions is not in the politician’s best interest! If there is another review into the financial services industry, the government is unlikely to drop commissions, but as compensation for not abolishing commissions, more compliance measures will likely be put in place instead. which means aggregators will be more necessary to brokers to deal with increased compliance.
While brokers could move to a fee-for-service model, abolishing commissions would likely mean fewer brokers, which would mean less competition and potentially lower access to advice for borrowers.
The loan manufacturing division margins for Australian Finance Group can be impacted by higher funding rates and competition. As the official cash rate rose in 2022, at the sharpest rate since the late 1980’s, higher funding costs compressed Net Interest Margins (NIM). Australian Finance Group’s net interest margin decreased in FY24 to 113bps from 136bps in the prior year.
Therefore, Australian Finance Group is not purely a distribution play, as it also provides loans, but both segments are dependent on the housing market in Australia. The property market it is not immune to downturns, and Australian Finance Group will make less money during periods when the numbers and values of transactions decline.
Does the Australian Finance Group (ASX: AFG) share price offer good value?
The Australian Finance Group share price is well off highs seen in late 2020, and trades on a trailing Price to Earnings (P/E) ratio of 14.5, and Dividend Yield of 5.2%, fully franked (~7.4% after considering franking credits). Australian Finance Group paid a fully-franked dividend of 8 cents in the 2024 calendar year. Since it is a capital-light business, I would expect to see dividends increase with profits.
While the Australian Finance Group share price is depressed, the business is showing signs of improvement, with the later part of FY24 showing improvements in the loan manufacturing division and growth in broker numbers (and settlements).
Australian Finance Group should benefit from technological advances, and it appears verification technology is improving, which will make things like verifying documents, credit checks, and applications easier and quicker with enhanced digital trust & data transformation technology.
Australian Finance Group has a good quality loan book with no recorded losses over the FY24 year. At the end of FY24 around 53% of loans had a Loan-to-Value (LVR) ratio under 70%, and around 32% of loans had an LVR of between 70-80%. Anything over 80% is generally considered a higher-risk loan. There have been no recorded losses for the securities book over the past two financial years, and they have only had $260,000 in bad debts in the 15 years since Australian Finance Group started offering loans.
Australian Finance Group expects the share of loans written by brokers to increase over the coming years as banks close branches. It says 2,100 bank branches closed in Australia between 2017 and 2023.
There have been no director buys or sells on the market in the last year. Founder and Non-Executive Director Brett McKeon owns 16,332,632 shares. Non-Executive Director Malcolm Watkins is also a founding director and owns 16,139,718 shares. Independent Non-Executive Director Craig Carter owns 1,400,000 shares, and the other board members each own smaller amounts.
Greg Medcraft, who is the former chairman of the corporate regulator ASIC, is on the Australian Finance Group board, suggesting compliance procedures at the company work well.
I (Chris Coe) have bought Australian Finance Group shares because it is a growing, capital-light business with recurring revenues. The Australian Finance Group share price appears to offer good value at around $1.55, based on a trailing P/E ratio of around 14.4 and a trailing grossed-up dividend yield of around 7.4%.
My hope is that Australian Finance Group is at an inflection point because it is moving out of a period of more intense competition from the banks. If this proves the case, I should see the earnings and dividend increase in the coming years, providing potential for capital gains if the share price follows.
Disclosure: The author of this article Chris Coe owns shares in AFG. The editor of this article Claude Walker does not own shares in AFG. Neither the author will trade AFG shares for at least 48 hours following the publication of this article. This article is not intended to form the basis of an investment decision and is not a recommendation. Any statements that are advice under the law are general advice only. The author has not considered your investment objectives or personal situation. Any advice is authorised by Claude Walker (AR 1297632), Authorised Representative of Ethical Investment Advisers Pty Ltd (ABN 26108175819) (AFSL 343937).