Strong Growth Prospects For Judo Capital

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

UBS has initiated coverage of Judo Capital with a Buy rating, echoing the assumptions of other brokers the bank’s growth prospects are more than solid. Not all agree, however.

-Judo Capital bounces back from a weak start
-Margin stabilisation and benign bad debts provide confidence
-Consensus of a 40% earnings CAGR over three years
-UBS initiates with Buy, Citi remains sceptical

By Greg Peel

Judo Capital Holdings ((JDO)) is a specialist, pure-play lender to Australian small and medium enterprises (SME). The company listed on the ASX in November 2021 and proceeded to lose -63% of its value through to October 2023.

The timing was unfortunate. Judo began losing value as the market anticipated the first RBA rate hike from 0.10% to fight inflation, and losses accelerated when the RBA first moved in May 2022. The stock bottomed out after the RBA made its final hike to 4.35%, and as hopes grew the next move would be a cut.

A year later, we’re yet to see a cut, despite the Fed and other central banks having now made their first moves. Economists expect cutting to begin in the first half of next year, but from that October bottom last year, Judo shares have rallied 100%, to be around three-quarters of the way back to their listing price.

In its earlier years, Judo suffered from an unstable net interest margin (NIM) and perceptions that an economic downturn would lead to a rise in bad & doubtful debts (BDD) among the bank’s small business borrowers. With the Australian economy now having slowed to a crawl, fears of a downturn persist, but Judo’s FY24 earnings result helped to allay many fears.

Stabilisation

The FY24 earnings result back in August met or exceeded broker expectations. Macquarie acknowledged post the release the company had “delivered on existing promises”. Importantly, BDDs grew only slightly.

While Macquarie considered management’s FY25 net interest margin (NIM) guidance of 2.8-2.9% to be ambitious, the broker upgraded to Neutral from Underperform.

Morgan Stanley went one better and upgraded to Overweight from Equal-weight. Management commentary and Judo’s second half trends provided the broker with greater confidence, leading to a belief operating leverage will drive a step-change in return on equity over the next two to three years.

Morgan Stanley also had less near-term concerns around credit quality after the non-performing loan ratio fell in the fourth quarter.

Morgans (Add) suggested if Judo’s targeted return on equity in the low to mid-teens is met, the stock should trade at a price to book value at or above 1x, which at the prevailing share price would generate a double-digit annualised return for investors.

Morgans nonetheless pointed out Judo will not pay dividends while it retains capital to support its loan growth aspirations. As a result, it is still labelled as high risk versus the major banks, given it is a challenger operating entirely in the SME area.

The FY24 result exceeded Ord Minnett’s (Buy) forecasts thanks to strong new business struck on stable margins. This broker observed an improvement in asset quality, reversing the trend set in its March quarter deterioration, and that management had controlled costs well.

Non-Believer

Reflecting late last month on Judo Capital’s rally over the past twelve months, which saw the bank’s shares trade north of book value, Citi suggested the market is likely ascribing a very high probability of management achieving its goal of “metrics at scale”.

This confidence was due in part, Citi assumed, from the guided stabilisation and recovery in the NIM, which had a non-linear path to its guided long-term 3%, and was a key reason for the de-rating of the stock last year.

While the market is more comfortable on NIM, Citi remained concerned regarding asset quality. FY25 guidance for a stable BDD charge looked optimistic to the broker, particularly when considering the growth in the loan book, “seasoning” of the last 18 months of strong growth and the impact the slowing economy may have from here.

Citi has incorporated a higher for longer BDD charge, and revised down FY25-26 cash earnings forecasts. This broker retains a Sell recommendation.

Believers

Goldman Sachs’ assessment of Judo’s FY24 performance was that the quality of the result was good. Profit beat the broker’s forecast on better NIMs and the BDD charge was no more than expected, with measures of asset quality better than expected.

Judo’s CET1 capital ratio fell to 14.7% from 16.2% at the end of the first half as capital was deployed into building scale, but Goldman had forecast 14.6%.

While Goldman Sachs took on board a steeper move to NIM’s in excess of 3%, consistent with management’s at-scale expectations, the broker reduced its earnings forecasts given the offset of lower volumes, more elevated FY25 expenses and a higher tax rate.

Yet, while the broker struggles to reconcile Judo’s FY25 profit growth forecast of 15%, Goldman likes the operating leverage in the business, believing this will drive very strong growth in FY26.

In particular, Goldman highlighted management has shown it can maintain growth in its balance sheet (up 20% year on year), and improving front-book lending spreads should bode well for FY26 NIMs, which the broker now forecasts to be greater than 3%.

Asset quality metrics have flattened out or improved and were better than Goldman had expected, hence, despite a forecast of 50% profit growth in FY26, and a return on tangible equity trending to more than 10% by FY27, the stock trades about in line with net tangible asset valuation.

Goldman Sachs retains Buy.

UBS has this week initiated coverage of Judo Capital with a Buy rating and a $2.10 price target. To put that into context, the consensus target among brokers monitored daily by FNArena was $1.64 prior to UBS’ initiation. Morgans has nevertheless since lifted its target to $1.92 from $1.65. The new consensus target, with UBS included, is $1.75.

Morgans lifted its Judo target in a report warning clients it retains an Underweight view on the major banks due to stretched valuation metrics. But outside of the Big Four, Morgans remains attracted to Judo Capital’s outstanding growth potential.

Judo’s current market share is around 1.5%, UBS points out. Ambitions to scale the business appear modest, based on the broker’s research, seeking to capture only 3.0% of the market despite current flow share at closer to 5.0%. The challenger bank, on UBS’ estimates, is likely to achieve the top end of at-scale guidance by FY29, with an expected return on equity in the low double-digit range (10.9%), something the broker believes the market has not fully priced in.

UBS’ positive thesis is underpinned by a forecast 40% three-year earnings per share compound annual growth rate.

Judo has carved out a credible niche in a highly competitive banking sector, UBS notes, characterised by the incumbency of the major banks. Judo’s ambitions to scale are likely to be supported by structural drivers within the broader business banking market and further commercial broker channel penetration. UBS forecasts Judo’s lending book could double in the next four years to around $20bn.

A lot has changed in terms of the investment case for Judo since the bank listed in 2021, UBS notes. The bank’s term funding facilities have rolled off, interest rates have increased by 425bps, offering credit cycle and funding cost implications, while competition has intensified in business banking.

Business lending is a higher margin product segment (more than 60bps above retail) for the banks, although Judo’s increased capital allocation is expected to reduce return on invested capital.

Given a consensus forecast of 40% annual earnings growth over the next three years versus 2% for the sector, Judo should trade closer to a 25x PE, UBS suggests, reflecting a scarcity premium around growth in both global banks and the ASX200.

Following UBS’ initiation, the six brokers monitored daily by FNArena covering Judo Capital have between them four Buy or equivalent ratings, one Hold and one Sell. The current $1.75 consensus target results from a range between $1.35 (Citi) to $2.10 (UBS).

Goldman Sachs has a Buy rating and $1.71 target.

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