Australian Finance Group: Formula to turn cash of 25cps into value of >$1.10ps

About the author:

Azib Khan
Author name:
By Azib Khan
Job title:
Senior Analyst
Date posted:
22 September 2021, 8:45 AM
Sectors Covered:
Banks

  • We believe AFG can use its surplus cash to acquire distribution such that the acquisition is ultimately >30% EPS accretive for AFG.
  • This prospect creates upside risk of >$0.85 per share to our current target price of (login to view).
  • Retain Add recommendation.

Potential to create significant shareholder value from surplus cash

AFG remains debt free and had unrestricted cash of $106.9m on balance sheet as at 30 June 2021. We estimate that AFG’s working capital requirement at the moment is ~$40m; meaning that we estimate unrestricted cash, net of working capital requirements, to be ~$67m as at 30 June 2021. This surplus cash equates to ~25cps, and this is the value of cash factored into our target price of $3.40.

However, there is upside risk to our target price from the perspective that this surplus cash of ~$67m can potentially be used by AFG to acquire distribution. We viewed AFG’s attempt to acquire Connective as an attempt to acquire more distribution.

Now that the Connective acquisition does not look to be proceeding, we expect AFG to look at other options in terms of acquiring distribution. While AFG may choose to hold an additional $15-20m of cash above its working capital requirement in order to provide comfort to warehouse funders and RMBS investors, we believe AFG can establish a debt facility for this additional cash if required.

Our view is that $67m can buy AFG a >5% increase in NPAT before any cost synergies and revenue synergies.

In terms of revenue synergies, we believe $67m can buy AFG a ~50% increase in total residential settlements. If we assume that AFGS’s percentage share of total AFG residential settlements remains unchanged, then this can ultimately result in a 50% increase in AFGS net interest income with all else constant. We believe such an increase in net interest income on its own can result in a 25% increase in AFG’s group NPAT.

We believe cost synergies on the aggregation side of the business can result in a further >5% increase in AFG’s group NPAT.

We therefore believe that the surplus cash of ~$67m can potentially buy AFG a >35% increase in NPAT, and this can potentially add >$1.10 per share to our AFG valuation on an ex-cash basis, meaning that we see potential for our valuation to increase to >$4.25 per share.

Should we worry about AFG’s risk profile upon such an acquisition?

We expect such an acquisition to ultimately result in AFG having an increased revenue skew to its AFGS business, which means increased balance sheet risk for AFG (in context of the Group) particularly by way of funding risks. Funding risks include the risk of dislocations in RMBS markets which would create funding issues for the AFGS business.

While AFGS’s credit risk will likely be limited to the extent of the subordination provided by AFG to the warehouse facilities and RMBS trusts, significant deterioration in the percentage of 90-day arrears could trigger an amortisation event in the warehouse facilities.

However, with regards to funding risk, the Australian Office of Financial Management (AOFM) has shown during the COVID-19 pandemic that it is willing to provide funding support to non-bank lenders during times of crisis.

With regards to the risk of an amortisation event, APRA has shown during the COVID-19 pandemic that it can provide capital and regulatory reporting exemptions to banks which flow through to non-bank lenders by way of loan deferrals not being treated as 90-day arrears.

It can therefore be argued that the funding risks associated with the AFGS business have now reduced assuming that the Federal Government has the fiscal capacity and willingness to provide support to non-bank lenders during times of crisis going forward.

Investment view and changes to forecasts

We have not materially changed our EPS forecasts. Retain Add recommendation.

Our target price, based on our DDM valuation, is unchanged at (login to view).

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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