My first ‘whisper stock’: Pepper Group Ltd

I mentioned 2 weeks ago that I’d received my first ‘whisper stock’. Having had a good look at it and reached no definite conclusions, I thought I would pass it on as an idea for readers who might be interested in taking it further themselves.

The company was Pepper Group Ltd (ASX: PEP), a specialty finance company that does a variety of lending including; banking in Korea, a JV doing unsecured consumer loans in Hispania, and a tonne of specialty home lending in Australia. They lend to people with blemished credit records in Australia. Not necessarily bad credits, their customers are typically people who would struggle to get loans from major banks, e.g. due to a bad debt in the past (even if it was eventually paid off completely).

As I understand it, Pepper borrows its funds from the big 4 banks. It then lends to its customers at a higher rate, and pockets the difference between the rates, plus fees. Most of its loans appear to be non-recourse to the company, either held in funding warehouses or packaged up and sold off into residential mortgage-backed securities (RMBS). With the increased spotlight on the big banks recently, Pepper has a good shot at picking up market share (and has been doing so in recent years). Pepper has about 50% of its market cap in corporate cash, and net tangible assets of $2.26 per share. So it is priced at about 1.3x book value, which is very cheap compared to the Big 4 banks.

And as my mate Dave might have said, I don’t know much when it comes to this type of business. Despite having a red hot crack at it, and a trawl through all kinds of industry documents and reports, I simply have come to no decision on Pepper. These are my issues:

1) I can’t predict what happens to its business in the event of a housing crash

It seems as though the liability for defaults rests on other people/bondholders. That is fine. But it is easy to envision profits and the number of deals being made plunging. Pepper is diversified internationally, sort of, but a fair chunk of its business and profits come from the Australian property market.

2) I can’t predict what happens in the event of a tighter funding market

I haven’t got a good read on what happens to Pepper’s funding in the event of adverse market conditions (housing collapse, credit crunch, et al). Theoretically as the cost of funding rises, Pepper just lifts the cost for borrowers and maintains its spread. This makes sense if the borrowers truly can’t go to a bank. I am a shares guy and do not know much about the market for the funding of bank loans. However I can envision a scenario where funding does not increase in price, but dries up entirely.

3) I don’t know its liability in the event of default (since Pepper writes its own equivalent of LMI)

Pepper uses Lenders Protection Fees (LPF), which it charges in place of lenders mortgage insurance (LMI). I have no idea and could not ascertain from its documents or website what exactly this is or what it means for Pepper. Presumably Pepper is not liable for defaults in its bonds or the funding warehouses – my first thought was actually that Pepper simply charges and pockets these fees (i.e., that they are not actually insuring anything), but I do not know.

4) I am having trouble seeing the upside

I don’t have a good read on the Australian property or banking industry. I used the assumption (plucked from thin air) that Pepper could maybe double its market share at the expense of other lenders in the next couple of years.  What are its shares worth in that scenario? Is today’s P/E of 8 the ‘right’ one?  Genworth Mortgage Insurance Australia (ASX: GMA) has a P/E of 8 and it’s on the hook for every shitty mortgage in the country. So Pepper should be worth more than this (depending on its liabilities as i noted above), maybe a P/E of 12ish and/or 1.5x book in ‘normal’ times. Either way I couldn’t construct a likely scenario where shares would more than double in the next couple of years.

This seems a fairly ordinary payoff given the way the Australian housing market looks at the moment. After 10 years of ‘more of the same’ (read: booming property market and lending) since the GFC, I wouldn’t want to bet on ‘more of the same’ for another 5 years or however long it might take for Pepper to become a 3-bagger plus. I have been persistently wrong about the banks in the past, and I could easily be wrong on Pepper – although that only reinforces the idea that I should steer clear of the company entirely.

Pepper certainly appears to be a well-run company, but I do not know enough to make a decision on it that would grant me a good enough chance of achieving attractive risk-adjusted returns. If you are selling December 2019 put options on Genworth on the cheap, however, please get in touch.

So I pass the idea off to readers, make of it what you will. It is not a recommendation.

And if you are knowledgeable about how Pepper’s business works, please drop me a line – I would like to learn more.

I don’t have any financial interest in Genworth Mortgage Insurance Australia or Pepper Group Ltd.

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