Judo Capital (ASX: JDO) provided a much better-than-expected first-half 2024 trading update and provided fiscal 2024 pretax profit guidance around 40% higher than our prior forecast. Net interest margins, or NIM, were down less than expected, operating expense growth was effectively restrained, and bad debt expenses were still very low.

However, target loan book of up to $10.7 billion by June 2024, up 20% on last year, is lower than the $11.3 billion we had forecast. Management appears to be leaning toward preserving margins and profits in the short term even if it means slowing loan growth.

Judo Capital is an Australian bank primarily focused on lending to Australian small and midsize businesses. Judo’s main lending products are business loans, equipment finance, lines of credit, and home loans. Personal, business, and self-managed superannuation fund term deposits are a key source of funding.

Increase in our fair value estimate

We have increased our fiscal 2024 pretax forecast by 43% to the top end of guidance at $113 million. The $34 million increase is roughly split 65% to lower operating expenses and the remainder to lower bad debt expenses.

The impact on revenue from the higher-than-expected NIM is offset by lower lending growth. First-half expenses increased just 5% on the second half last fiscal year, tracking materially below management’s previous guidance that fiscal 2024 expense growth would be around 22%.

Our forecasts assume annual expense growth of 9% per year to fiscal 2028. To support our 16% per year loan growth forecast to fiscal 2028, we still expect ongoing investment in bankers and technology, and the cost of attracting and retaining staff is also likely to rise as banking industry profitability recovers. Our fiscal 2025 profit forecast increases 6%, on modestly higher NIM and lower operating expenses, while profit forecasts are not materially changed.

Our fair value estimate increases by 9% to $1.20 per share after incorporating stronger earnings. Shares jumped over 16% on the 23rd of January after the positive trading update, but remain at a modest discount to our revised fair value estimate.

NIM of 3.02% in the half fell from 3.34% in the prior half. Repayment of the term funding facility is materially increasing funding costs for Judo.

Business strategy

Judo Capital, or Judo, began as a nonbank lender in 2016, using seed capital and debt facilities to establish itself as a lender to Australian small and midsize businesses, or SMBs. Judo received a banking deposit license in 2019.

Among its competitors are the big four Australian banks which collectively have around 70% market share of total business loans. Judo has less than 1% share of total Australian business loan market, but we estimate closer to 2% of the SMB market.

Judo’s strategy is to pay top of market rates on term deposits, and charge an above-average return on its lending to generate a net interest margin above 3%.

Judo justifies higher rates on its superior customer service offering, including a dedicated banker, fast approvals, and a less rigid approval process. Taking modestly greater risk and hence being compensated with higher rates is likely contributing to Judo’s growth.

We think Judo can continue to grow, but exponential growth achieved in recent years will be difficult to maintain. Having access to cheap funding from the Reserve Bank of Australia during the pandemic allowed Judo to lend to more customers than it typically would target, at reasonable attractive margins and return on equity.

As its funding costs rise by more than peers, Judo will now likely have to be more selective on which loans it funds. In fiscal 2022, Judo’s lending margin was 4.5% over the bank bill swap rate. By June 2023, it was down to 3.7% over BBSW.

Moat rating

Capitalism is competition. And while companies competing for new business by creating better goods and services at cheaper prices is positive for consumers it does not benefit shareholders. Companies are forced to spend more money on research and development and marketing. When combined with lower prices that means lower profits.

At Morningstar, we believe the best businesses are able hold competition at bay through a sustainable competitive advantage or moat. Over time this leads to higher profit margins and higher returns on capital invested in the business. Both very positive outcomes for investors.

We do not believe that Judo Bank has an economic moat, as it lacks cost advantages (funding, operational, credit) or boasts any material switching costs for customers in the Australian banking system.

The four wide-moat-rated Australian major banks account for almost 70% of the business loan market. As a small market player, Judo’s market share in its target small to midsize business segment is very small at less than 2%. For comparison, the market leader National Australia Bank (ASX: NAB) has around 27% share of SMB loans.

Judo’s small loan book, and higher funding and operational costs relative to peers, translated to return on equity of about 5% in fiscal 2023, compared with low-double-digit returns for the majors.

Judo is at a funding cost disadvantage relative to the Australian major banks. It pays more for both customer deposits and wholesale debt. While a source of funding for larger banks is a large number of customers' at-call accounts which earn low or no interest, Judo is solely reliant on term deposits.

With no branches and a limited product offering, plus a desire to grow deposits and loans faster than the market, Judo also pays market-leading rates on term deposits. Judo’s term deposits are offered directly to retail customers, businesses, and self-managed superannuation funds.

Funding costs are also higher than for major banks on wholesale credit, comprising around 20% of Judo’s midcycle funding. The majors have better credit ratings.

Further highlighting the difference in funding costs, in October 2023, Judo announced an additional Tier 1 capital note issuance at a margin of 6.5% over the 1-month bank bill swap rate, while National Australia Bank was able to issue similar notes a few months earlier and only pay a margin of 2.2% over BBSW.

To offset the higher funding costs and make a net interest margin above 3%, on average Judo aims to earn 50 basis points more than the peer group in return for dedicated customer service, speed of approvals, and a less rigid approval process.

It is likely that Judo is taking modestly greater risk and hence being compensated with higher rates on customers. While we believe there is a market for such an offering, the fact that Judo’s average lending rate fell materially in recent years as the loan book grew rapidly suggests it is difficult to maintain rapid growth and maintain such a material premium. In fiscal 2022, Judo’s lending margin was 4.5% over the BBSW, but by June 2023 it was down to 3.7% over BBSW.

The cost/income ratio of 54% is much higher than the cost/income ratio of the major banks —in the low to mid-40% range. Despite the major banks supporting a much larger product suite (loans, payments, transaction accounts, personal loans, and credit cards), lower funding costs and operating leverage from a large customer base result in much greater efficiency. Major bank cost/income ratios in business lending average around 35%, with Commonwealth Bank currently the lowest at 30%.