Is Judo Capital Too Ambitious?

This story features JUDO CAPITAL HOLDINGS LIMITED. For more info SHARE ANALYSIS: JDO

While the Judo Bank share price rose following FY24 results, some analysts challenge management’s upbeat outlook on asset quality.

-A strong second half for Judo Bank in FY24
-Some brokers harbour doubts around asset quality
-Management expects 15% profit growth in FY25
-Upcoming return on equity step-change, says Morgan Stanley

By Mark Woodruff

Due to the substantial share price re-rating of Australian banks this year, which generate only a fraction of the expected growth of Judo Capital Holdings, better known as Judo Bank ((JDO)), Macquarie has decided to upgrade its rating from Underweight.

The broker’s new Neutral rating balances the bank’s future growth prospects against potential credit quality and competition risks, which FNArena explores further below.

Judo modestly beat profit expectations in FY24, but the second half showed improvement, and the market was clearly happy with a greater level of detail underpinning unchanged guidance for around 15% profit growth in FY25, suggests Citi, as the share price jumped by around 10% in reaction.

Improving asset quality and the likelihood of more sustainable interest margins buoyed investor sentiment, suggests Ord Minnett. Also, second half profit came in 5.3% ahead of the consensus forecast.

The worst has now likely passed, according to Barrenjoey, which suspects the market was relieved partly because earnings have been in a consistent downgrade cycle since listing in November 2021.

Agreeing with Ord Minnett, this broker also points out competitive threats had raised concerns over the sustainability of Judo’s net interest margin (NIM).

Contributing the most to Judo’s results, net interest income (NII) is derived from the difference between interest earned on lending and investment assets and interest incurred on customer deposits and wholesale debt raised to fund these assets.

In the second half of FY24, total income was around 1% ahead of consensus and the NIM slightly improved to 2.85%, offset by slightly smaller Average Interest Earning Assets (AIEA).

Prioritising relationship-led lending, supported by a cloud-based digital technology architecture, Judo is a small-to-medium enterprise (SME) banking specialist and a challenger bank to the big four banks in Australia in this space.

Investors should be aware of heightened credit risk in SME business lending compared to home mortgage lending.

Costs arise from running the business such as staff, occupancy, and technology related expenses.

Listing on the ASX in November 2021 at $2.10, the shares quickly peaked at $2.48 before grinding lower over the following two years to 80c, and then staging a comeback to $1.54 at the time of writing.

Following the release of FY24 results, the average 12-month target price in the FNArena database has surpassed this share price after rising by 31.2% to $1.64.

After hitting an earnings nadir in the second half of FY24, Morgans believes the base is now set for management to attain guidance for 15% profit growth in FY25.

In the second half, pre-provision profit declined by -9% (ex-recurring items) but exceeded forecasts by the analysts and consensus by 4%. The profit decline of -37% and no dividend were both as expected.

In upgrading to Overweight from Equal-weight, Morgan Stanley cites second half trends and management commentary on key drivers as providing greater confidence in the potential for operating leverage to drive a step change in return on equity (ROE) over the next two-to-three years.

The common equity tier-one (CET1) ratio fell by -1.5 percentage points (ppt) to 14.7% in FY24, mainly due to an increased loan portfolio, explains Ord Minnett.

Loan growth, lending risk weights and higher operating risk continue to weigh on Judo’s capital position, notes Barrenjoey, but as Judo’s loan book continues to expand towards its target $20bn metrics-at-scale in around FY27, the CET1 ratio is expected to slide down towards 10.5-11.0%.

Evans and Partners remains uneasy about the downward CET1 trajectory to an at-scale loan book and remain similarly uncomfortable around the asset quality outlook.

Asset quality

After a poor March quarter, notes Ord Minnett, non-performing loans as a proportion of gross loans and advances (GLA) fell to 2.31% from 2.63% from the prior quarter.

While management is guiding to improved impairment charges in the near-term relative to the second half of FY24, Macquarie believes this may be a difficult act to pull-off given a rapidly growing lending book.

This broker still envisages impairments will improve over the next few periods as the book grows to full scale.

A potential soft-landing scenario for the Australian economy is a key positive for the bank, as it removes the credit cycle risk. Deposit spreads may normalise as rates decline, providing an upside to Judo’s longer-term margins.

Like Macquarie, Citi is dubious around the “brave call” by management which implies guidance the bad and doubtful debt (BDD) expense will fall to just 60bps of loans in FY25, as it is inconsistent with the experience of peer banks at this point of the cycle.

Certainly, Evans and Partners has observed notable deterioration in SME asset quality elsewhere this reporting season.

Improving margins

Apart from an improving margin on new loans and positive recent deposit pricing trends, Morgan Stanley’s increased confidence also stems from management guidance for a second half FY25 margin recovery.

The recent and expected net interest margin (NIM) journey is instructive.

The average NIM declined by -17 bps in the second half and exited FY24 at a trough rate of 263 bps. Now, guidance is for a lift to 275-285bps in the first half of FY25 before trending up to 290-300bps in the second half and exiting FY25 at around 300bps.

Term Funding Facility

Also raising Morgan Stanley’s recovery hopes is better-than-forecast progress on the funding mix and the end of Term Funding Facility (TTF) refinancing.

Indeed, Macquarie suggests the key highlight from the FY24 results is management’s confidence in the FY25 earnings growth trajectory without the TTF.

The TTF is a program introduced by the Reserve Bank of Australia (RBA) during the covid pandemic to provide low-cost funding to banks. Management believes this program masked the underlying improvement in pre-provision profit and that a “significant operating profit trajectory” will emerge in the second half of FY25 and beyond.

Loan growth and capital management

FY25 loan growth is guided to be between $2.0-2.3bn, an adjustment of the range from $2.0-2.5bn previously, but up from $1.8bn in FY24. This new guidance is still below the average $2.7bn/year achieved across FY22-23, notes Morgans.

Driving this loan growth, suggests management, will be new regional locations, additional bankers, new SME product segments, expanded SME product offerings, and increasing banker productivity.

Management does not intend paying dividends as it retains capital to support its significant loan growth aspirations.

Outlook

Judo’s balance sheet growth and pipeline remain strong, highlights Macquarie, and management seems confident about near-term lending spreads. As the franchise is de-risked and returns improve, Judo should justify a higher multiple, in the broker’s opinion.

Citi highlights there are still risks around costs and asset quality, which are potentially not factored in given the re-rating of the stock price.

The average target price of five covering brokers updated daily in the FNArena database of $1.64 following FY24 results suggests just over 6% upside to the latest share price.

Of the five brokers, there are four Buy (or equivalent) ratings, while Citi remains at a Sell.

Outside of daily coverage, Barrenjoey and Evans and Partners have respective Overweight and Neutral ratings and targets of $1.80 and $1.30.

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