James Gruber: Nathan, you've initiated coverage on Judo Capital. Can you tell us about the business?

Nathan Zaia: Yeah. So, it's basically a lender to small and medium businesses across Australia. It started out using private equity funding to lend to small and medium businesses, the sort of gap in the market where they thought major banks have stepped back a bit on service levels, are not lending to certain customers that Judo thought were good credit quality. So, they stepped in to fill that gap. They later got a banking license. They were able to accept deposits. So, they've really focused on term deposits, given they don't have branches and savings accounts and all that sort of thing. So, they focused on that, and they're now using that to support continued growth of the loan book. So, it's a pretty simple model, I guess, of using term deposits to fund SME loans. About 10% of the book is housing loans, and that's mostly business owners using their home as security for the business loans.

Gruber: They've had some strong growth. What's driven that?

Zaia: Yeah. I think they did find a gap in the market that management has executed on really well. We don't think they have a funding cost advantage over the majors or a cost advantage in general. But yeah, their focus has been using that relationship between banker and customer. And the aim is really to make sure that the customer is satisfied to get them the loan approved quickly. I think more approvals to maybe customers that were struggling with majors or some that just were not happy with the service levels that they were getting with the majors.

I'll give you an example. Major banks, they've centralized a lot of their functions for efficiency benefits. So, you might be a customer, you're ringing their call center, and you might be speaking to someone different all the time. Or you might have a loan application and you're slightly higher levered than the banks willing to accept. Judo might look at you as a potential buyer and say your cash flows are really strong, got a really good business plan here, we're willing to back you. So, a little bit more flexibility. And I think that's helped the growth along.

The other thing is the term funding facility. So, Judo had access to this really cheap funding. And they didn't need to charge as much of a premium on their loan anymore to make a good margin. So, I think that's widened the potential customer base that they could go after.

Gruber: What's the outlook for the stock?

Zaia: Yeah. I think there's still plenty of runway in terms of loan growth. In the short term, they do have to refinance that term funding facility. So, you're looking at funding that costs you 0.1% current term deposit rates, they're paying a 5.35%. So, there's a big step up in what they're going to have to pay for a big portion of their funding. And to counter that, they need to reprice their loans to small businesses and really target customers where they can get a premium over the average that small businesses are charged. So that's a headwind for the short term. But I think once you get through that, we think they can generate margins that they need to be pretty profitable over the long term.

Gruber: What are the key risks then?

Zaia: Yeah. I think like every bank, there's risks around the loans and the margins. But I think a bigger one for Judo is around bad debts. So, this is a business that's focused on SME. It doesn't have a long track record. So, there could be potentially higher bad debts than we're expecting if we do have an economic downturn. So, we mid-cycle assume a loss rate of around 0.7% of their loans. If that were to go up to say 2%, then the bank wouldn't be profitable anymore. And that is a pretty dire situation. We're talking early 90s type recession where we saw SME loans that high. So, we don't think it's likely or it's not our base case. That's for sure. But yeah, it is a risk, just how much bad debts could eat away at profits over time.