During the September meeting, the Reserve Bank of Australia decided to hold the cash rate at 4.35% despite mounting pressure from the US Federal Reserve and Bank of England who both cut rates recently.

The decision was attributed to the fact that current inflation levels are nowhere near the sustainable targets that the RBA set.

We recently initiated coverage on Liberty Financial Group (ASX:LFG), a high-risk lender who presents an interesting proposition in the context of the interest rate environment.

Introducing Liberty Financial Group LFG

  • Moat: None
  • Fair Value: $4.50
  • Last Price: $3.44 (as at 8th October 2024)
  • Price to Fair Value: 0.76 (Undervalued)
  • Fair Value Uncertainty: High

We initiate coverage of nonbank lender Liberty Financial Group (“Liberty”) a financial services business with operations across Australia and New Zealand. The group operates within several lending sectors such as housing, commercial, personal and business finance.

Liberty listed in the latter half of 2020 but has operated as a nonbank lender since 1997. Due to high funding costs the firm does not hold a competitive advantage over the big 4 banks. Instead, Liberty competes in the mortgage market by extending credit to borrowers overlooked because of poor documentation or are viewed as too high-risk. This market does not appear to be expanding but we anticipate strong earnings growth to come primarily in the motor finance and self-managed superannuation (“SMSF”) lending segments. These are areas the banks have exited.

Whilst group margins have been squeezed, there appears to be a modest stabilisation in the horizon as funding costs begin to fall. Credit losses remain a key risk however this is deterred by Liberty’s strong track record in limiting losses.

Measuring up to the banks

Whilst commanding a miniscule portion of the mortgage market share, the company’s residential loans represent over half the loan book. Liberty is increasingly moving towards capturing motor finance and SMSF operations that banks have largely divested due to regulatory pressure and higher capital requirements. Liberty competes well in these segments with a track record of growth, leveraging access to funding, distribution partners, and customer service.

Liberty falls short of a moat rating as natural customer attrition or occurs due to a lack of cost advantages and minimal switching costs that typically support bank moats. Nonbank lenders target borrowers with low levels of documentation who fail to meet serviceability buffer requirements or have blemished credit histories. In return for this risk, Liberty charges higher interest rates on these loans. The downfall here is that many new borrowers that the lender attracts will eventually satisfy bank lending criteria and can switch with ease. The company loses pricing competitiveness at this point. In addition, customers are already using other banks meaning they can easily move to them if motivated by better rates or convenience.

Despite this, the larger loan book also means the lender competes for lower-risk/lower-rate borrows in addition to the ones it can charge a higher rate. Approximately 30% of the current loan book is classified nonprime, meaning the remainder is potentially exposed to broad industry wide price competition.

Strong financial position

Liberty is well-positioned with warehouse funding facilities far exceeding annual loan growth, providing flexibility in the case of a temporary securitisation market shut down. As at June 2024, total unused finance facilities sat above $4 billion compared with annual loan growth of around $800 million in the last five years.

Leverage (measured by assts/equity) sits around 13.5x which is much lower that of any other nonbank lenders listed on the ASX. The more conservative balance sheet lends to slightly cheaper funding in comparison to other listed peers.

Rate cuts impending

Despite an uncertain outlook on the future of interest rates, all the big four banks forecast that the RBA will drop the cash rate by May 2025 at the latest.

Falling rates would result in lower funding costs for Liberty, theoretically increasing their ability to compete. On the other hand, major banks would have little to gain given their funding is essentially free.

Furthermore, we expect regulators to closely scrutinize more risky lending from major banks to prevent another round of sky rocketing house prices. Consequently, lenders like Liberty become much more attractive to borrowers.

Is it a good buy?

We believe Liberty stands to gain from industry tailwinds such as population growth, increasing housing demand and tight credit requirements by ADIs.

Our fair value estimate for Liberty is $4.50 per share, implying a price/earnings ratio of 9.0x and dividend yield of 6.7% on fiscal 2025 forecasts. We assign an 11% cost of equity which reflects funding risk and exposure to higher-risk borrowers.

It’s stapled security structure results in a low corporate tax rate, but also means that distributions are unfranked. Our forecasted payout averages 65% of earnings, comparable to the previous three years and within the firm’s target range of 40% - 80%.

Bulls say

  • Tighter credit criteria imposed by banks push customers to look for solutions among nonbank lenders like Liberty.
  • Liberty’s simplified application process, fast approvals, and options for alterative verification attract brokers and borrowers.
  • Regulators impose overly restrictive lending standards on major banks, which increases demand for nonbank loans.

Bears say

  • Competitors looking for market share gains underprice risk and force Liberty to follow or lose market share.
  • Economic conditions worsen materially, and Liberty’s nonprime customers could experience higher risk of default. This could also put pressure on the lender’s access to funding in the future.
  • Liberty is unable to expand and is losing market share in residential mortgages due to intense competition from banks.

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