Earnings season always has its winners and losers.

One of the winners this time has been Judo Capital (ASX: JDO), which reported strong loan growth – up 20% versus mid-single digit growth for the broader banking sector – and saw a further leap in its share price.

Morningstar’s banking analyst Nathan Zaia was impressed Judo's results. But he thinks that Judo’s share price has a lot of optimism baked in at current levels.

Some context

Judo started as a nonbank lender in 2016 and received a banking deposit license in 2019. Its goal is to break the dominance of Australia’s big four banks when it comes to business lending, with a focus on small and medium sized companies.

Judo’s strategy is to pay attractive rates on retail term deposits and charge an above-average return on its lending to generate a net interest margin above 3%. Judo justifies higher rates with its superior customer service offering, which includes a dedicated banker, fast approvals, and a more flexible approval process.

Although Judo still has less than 1% of Australia's business loan market (and an estimated 2% of the small and medium business market), its growth over the past few years has been impressive. This slide from the company’s 2024 results presentation shows how their loan book has grown since 2020.

judo-loan-book-growth

Over the last four years, the company’s loan book has grown from $1.8bn to $10.7bn. This represents a compound annual growth rate of over 50%, albeit from a small base. Judo’s results featured forward guidance that incorporated another 20% growth in loans next year.

Morningstar’s Nathan Zaia thinks that Judo can double the size of their loan book to around $20bn by 2028. But he is less optimistic about how much of Judo’s loan growth can be converted into profits.

Judo’s management team have targeted a cost/income ratio (which measures operating costs as a percentage of operating profits) approaching 30% as Judo reaches scale. This would be a big fall from the 56% ratio seen in fiscal 2024, with a lower percentage being better as it means more revenues translating into profits.

Seeing as major banks generally achieve cost/income ratios of around 35% in their business lending segment, this target seems ambitious. Although Judo doesn’t have legacy IT systems, branches or a wide product range to support like majors do, it is a still a high-cost lender in many other respects.

A high cost lender

The first source of these higher costs come from Judo’s funding disadvantage.

Unlike the majors, Judo does not have low-interest at-call deposits. Instead, it relies on offering term deposits to customers at attractive rates of interest. The majors can also obtain far cheaper wholesale and Tier-1 capital funding than Judo thanks to their higher credit ratings. With this in mind, there is always a worry that banks with lower funding costs could try to entice customers away with lower interest rates that Judo simply cannot match.

Judo’s operational costs are also higher. In addition to Judo’s far smaller scale, this stems from the company’s strategy of providing a higher touch service. Each Judo banker currently serves an average of 31 customers. This compares to a customer/banker ratio of over 100 for most of the majors, who have turned to technology and processes to reduce the time spent with customers.

Given that Judo’s strategy hinges on providing a more personal service in return for higher interest rates, Zaia thinks it will be hard for Judo to become as efficient as management are targeting.

Efforts to increase the number of consumers or size of the loan book each banker is responsible for could dampen the success that Judo has enjoyed in recent years. Both in regards to Judo’s value proposition to borrowers and its ability to look more closely into each potential loan.

What might Judo be worth?

Zaia’s $1.30 Fair Value estimate for Judo shares implies a price-to-book ratio of 0.9 and a price-to-earnings ratio of 17.

His valuation assumes that Judo can grow loans in the low double-digits for the next five years, see its cost/income ratio improve to around 42% and earn an average net interest margin of around 3.1%. Net interest is the difference between interest earned from borrowers and paid to depositors.

Zaia’s valuation also baked in a slightly higher bad debts ratio than industry averages.

In extending credit to customers that major banks refuse due to more systematic approval processes, Judo could end up with a riskier loan book than peers. Judo bankers are mostly generalists and could be less aware to sector specific risks than the business bankers employed by many major banks.

Judo may be able to overcome these risks through its focus on spending more time to better understand the businesses' cash flows, collateral and future prospects. But as Judo is still the new kid on the block, the resilience of its loan book is still untested through a whole business cycle.

At a current share price of around $1.60 per share, Judo trades at more than a 20% premium to Zaia’s Fair Value estimate. This suggests that investors think Judo can grow its loan book more quickly, more efficiently or with less bad debts than Zaia thinks is likely.

Judo Capital Holdings

Star Rating: ★★
Fair Value estimate: $1.30
Share price August 21: $1.60
Moat rating: No Moat

More earnings season articles:

Get more Morningstar insights in your inbox

Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.