Pepper Looking Hot At Current Levels

By James Dunn | More Articles by James Dunn

Pepper has been able to serve a huge segment of the mortgage market that was massively under-served by traditional lenders.

Specialist financial services company Pepper Group (PEP) enjoyed a five-month honeymoon on the Australian Securities Exchange (ASX) after its July 2015 listing, but 2016 was not kind to the stock.

Pepper made an excellent debut on the stock market, closing its first day at $3.30, up 27% on the $2.60 issue price. By October 2015 the stock was trading at $3.84, but the first hints of gravity were starting to be felt. Pepper entered 2016 at $3.50 and ended it $2.45 – back below its issue price.

The company did very little wrong. In 2015 (Pepper uses the calendar year as its financial year) Pepper Group posted an underlying profit of $48.6 million, up 38%, beating both its prospectus and analyst consensus forecasts, while revenue rose 25% to $527.7 million. The bottom line was dragged down by a 38% rise in expenses to $521 million, attributed to increased borrowing costs and some float expenses. As a result, statutory profit fell 91 per cent to $3.5 million.

Then for the June 2016 half-year, revenue rose by 41% to $326 million, and underlying net profit grew by 41% to $23.6 million – lagging statutory profit, which surged to $24.4 million, from $3.8 million in June 2015.

Pepper Group has given 2016 guidance that says management expects to report adjusted (underlying) net profit of $59 million. On Thomson Reuters’ collation, analysts expect Pepper to report earnings per share (EPS) of 33.2 cents for 2016, from which it will pay a fully franked annual dividend of 7.5 cents. For 2017, analysts expect EPS of 38.4 cents and a dividend of 8.6 cents.

At $2.41 (which capitalises Pepper Group at $720 million) that prices the stock on just 7.3 times expected 2016 earnings, and 6.3 times expected 2017 earnings.

The analysts’ consensus price target for Pepper Group is $3.11 – or 29% higher than the current price.

So, with a profitable company trading below its issue price – which itself was cheap enough, given that the initial public offering (IPO) was repriced before issue from 12 times forecast 2015 net profit to 10 times – what is going on?

I think you can make a good case that the market doesn’t understand Pepper Group well.

Yes, it’s a residential mortgage lender, and the market is worried about an Australian housing bubble.

But Pepper is a unique beast.

At its heart, Pepper is a specialist non-bank lender, concentrating in the “non-conforming” loan sector. The bulk of its loan book is non-conforming borrowers, so named because they typically do not “conform” to prime loan standards, and thus could not obtain home loans from banks or other prime lenders – because they were self-employed, and found it difficult to prove their income and savings history, or had adverse credit events in the past, or were seeking to consolidate multiple debts.

These borrowers typically do not fit into the banks’ automated credit ‘scoring’ models: if they can get a home loan from a traditional bank, they will usually face a punitive interest rate.

Pepper’s main business is taking wholesale funding from the domestic Australian banks and wholesale investment institutions around the world, and applying its proprietary credit assessment skills to offer home loans to non-conforming customers.

To do this profitably, Pepper conducts a forensic bottom-up review of each borrower’s credit, so as to understand that borrower’s unique situation, and price that individual risk accordingly, at a risk premium to the banks’ standard variable home-loan rate. The company self-insures its loans: it does not rely on external underwriting support (e.g. lenders mortgage insurance). It focuses on the “near prime” segment.

This means that Pepper has been able to serve a huge segment of the mortgage market that was massively under-served by traditional lenders. Pepper says the main reason why borrowers are classified as non-conforming is because they have “unusual” income patterns and circumstances – this represents one-third of the market. The company does not really compete against the big banks: it works in market niches where the banks don’t want to be active.

The advent of the global financial crisis in 2007 kicked off two major changes to Pepper Group, when it moved into servicing home loan portfolios of other lenders: as the GFC bit, many non-bank lenders became distressed, and mortgage portfolios (funded either by the major banks or global investment banks) that required a loan servicer to step in. Looking for a new source of cash flow, Pepper realised that the skills involved in managing its own portfolios could easily be applied to managing and servicing any portfolio. In 2011 this strategy was vindicated when it took over the $5 billion GE mortgage portfolio in Australia and New Zealand – only $400 million of which was in the company’s signature non-conforming space.

The other big change was taking its skills to overseas markets. In September 2012, Pepper bought the GE Money loan portfolio in Ireland (now Pepper Ireland). It followed this with the March 2013 acquisition of Spanish non-bank lender Celeris, now Pepper Spain; and in July 2013, it acquired Oakwood Global Finance, a UK non-bank lender that had been established by Culhane in the early 2000s: it became Pepper UK.

In September 2013, after investigating the South Korean market for two years, Pepper bought a small mutual savings bank with about US$150 million in loan assets and two retail branches in and around the Seoul area. (Now known as Pepper Korea, this is Pepper Group’s only actual bank.

In May 2015, Pepper moved into the high-growth consumer finance markets of Hong Kong and southern China, buying a 12% stake in the Hong Kong and Shenzhen consumer finance businesses of Standard Chartered plc – known as PrimeCredit and Shenzhen PrimeCredit – as part of a consortium led by China Travel Holdings Company Limited. Pepper supplies its consumer credit expertise, which PrimeCredit is leveraging into the fast-growing Chinese consumer finance market, through its Shenzhen hub.

Pepper now operates in:

  • Mortgage lending – non-conforming, near prime and prime residential lending, with some legacy acquired prime portfolios – Australia, UK, South Korea, Spain and Ireland.
  • Unsecured consumer lending – personal loans, point of sale lending, auto loans, equipment finance and credit cards – Australia, South Korea, Spain.
  • Third-party servicing – residential mortgages, commercial mortgages and consumer finance receivables – Australia, UK, Spain and Ireland.
  • Advisory – commercial property advisory and portfolio due diligence services – Australia, UK and Ireland.

In 2015, Australian/New Zealand lending revenue rose by 85.6%, while overseas landing revenue grew by 35%.

In July, Pepper announced that it will partner with Spain’s Banco Popular in a 50-50 joint venture in Spain’s unsecured consumer finance market, and the partners will “act together to pursue new business opportunities in other territories.” The joint venture will be the fifth-largest in Spain’s point-of-sale finance market and will have access to Banco Popular’s customer base. Banco Popular will take a 5% equity stake in Pepper Group, and will subscribe to up to $100 million worth of Pepper’s shares over the next five years, subject to shareholding cap of 19.99%.

Australian investors could be forgiven for looking at this deal and thinking, “unsecured lending in a country with unemployment above 20% – what is Pepper thinking?” But that is precisely what the company has done since it was founded in the late 1990s: look closely at areas that other financial players are not keen on.

And the Banco Popular deal adds further diversity to Pepper’s funding base, which was also augmented in 2016 by the sale of $800 million worth of home loans, and the launch in July of a $700 million issue of residential mortgage-backed securities (RMBS) backed by non-conforming home loans. The issue – Pepper’s 17th RMBS issue – was the largest non-conforming RMBS deal the company had ever done, and the largest non-conforming mortgage securitisation in the Australian market since 2006.

The RMBS deal was originally marketed at $600 million, but strong demand from both domestic and offshore investors saw the issue raised to $800 million (and even that was heavily over-subscribed.) That Pepper can get these kinds of issues away tells you a lot about what wholesale investors think of its assets.

Investors do have to watch Pepper’s loan risk, the vast bulk of which resides in Australia. At the half-year, the company’s Australian and New Zealand delinquency rate was very low, at 1.36%, and since 2003, annualised cumulative losses have run at 0.1% a year. Last year, about 10% of total loans were classed as ‘past due but not yet impaired’ – investors will be keen to see from the 2016 numbers that this has improved.

But investors should also recognise Pepper’s high degree of expertise in the market sectors in which it chooses to participate. Under its Pepper Money brand, Pepper is a broad-based consumer finance company, with a range of products including prime and non-conforming residential mortgages, auto loans and unsecured personal loans. The company is ambitious to expand its global reach – and at these cheap price levels, Pepper appears to represent pretty attractive value. Virtually everything Pepper does is higher-risk than Australian financial services investors are used to – but it has an outstanding track record. And with Banco Popular on the share register, there is the potential for corporate activity to add further spice.

About James Dunn

James Dunn was founding editor of Shares magazine and has also written for Business Review Weekly, Personal Investor, The Age and Management Today. He was subsequently personal investment editor at The Australian and editor of financial website,

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