Mortgage Choice Limited - Why I bought it

This is a copy of the document I wrote myself for Mortgage Choice Limited (ASX Code : MOC ). This was written before I bought the stock so that I could convince myself the stock was a good stock to own. It was particularly thought out as it was the first purchase for my self managed super fund.
Overview
Mortgage Choice Limited (MOC) operates a Franchise network which as at 30 June 2005 comprised 407 franchises (570 brokers) located throughout Australia. MOCs brokers advise borrowers on the range of home loan products available, assist them in the selection of a product that are suitable to their needs and submit loan applications on their behalf. The Company is focused on residential lending for owner-occupiers and investors, and originates home loans on behalf of a panel of 28 lenders

Company Strategy
MOCs strategy is to grow organically through the expansion of its franchise network. The strategy is appealing as it requires minimal capex expenditure.
Customer relationship marketing initiatives and training programs have been implemented to convert more leads, while the Client for Life initiative has been created to retain loans for longer. The SALES framework announced in June 2005 represents strategic focus on Strong marketing, Add-ons, Lender partnership, Efficiency and Shop growth.
MOC has indicated long-term growth strategies may include acquisition of compatible businesses and product diversification. Other strategies include the expansion of new retail premises in shopping centres which is expected to continue being rolled out throughout 2005. In June 2005 MOC confirmed its loan book stood in excess of $21.7bn, having grown 23% since 30 June 2004. Trailing commission rose as percentage of total income to $53.5 million representing 48.4% compared with 40.5% in the pcp. The FY05 result was driven by a combination of higher than anticipated trailing commission income.
MOC will have to maintain and build upon the relationship with its lenders to remain competitive within a slowing housing market and greater competition between lenders.
MOC has indicated that franchise network growth slower than anticipated Mortgage Choice reported NPAT up 27.92% to $12.74m for the year ended 30 June 2005. Revenues from ordinary activities were $110.51m compared with $102.89m last year. Diluted EPS was 10.9 cents, compared to 9.06 cents last year. The final dividend declared was 6.00 cents, taking the full year dividend to 9.8 cents

Instutional Ownership
A stock requires institutional ownership if it is to grow. This is because it is mainly the institutions that push the price of stocks higher with their ever increasing inflow of money (from superannuation). If a stock has too much institutional ownership it makes the stock stagnant and/or a favourite for speculators. The top shareholders are below: (Institutions are in blue)

Shareholder	Shares	Percentage of Company
National Nominees Limited	16,212,502	13.79
R G Higgins	10,366,583	8.82
Ochoa Pty Ltd	9,620,000	8.18
Basscave Pty Limited	9,520,000	8.1
P G Higgins	8,911,534	7.58
J P Morgan Nominees Australia Limited	8,589,174	7.3
RBC Global Services Australia Nominees Pty Limited	7,302,727	6.21
RBC Global Services Australia Nominees Pty Limited	7,040,009	5.99
ANZ Nominees Limited	5,334,891	4.54
Invia Custodian Pty Limited	2,810,000	2.39
Health Super Pty Ltd	2,067,159	1.76
SCJ Pty Ltd	2,000,000	1.7
SCJ Pty Ltd atf Jermyn Family Trust	2,000,000	1.7
Westpac Custodian Nominees Limited	1,572,195	1.34
AMP Life Limited	1,364,464	1.16
Bass Equities Fund No 1 Pty Limited	1,153,960	0.98
RBC Global Services Australia Nominees Pty Limited	1,034,985	0.88
Cogent Nominees Pty Limited	995,479	0.85
Cogent Nominees Pty Limited	895,161	0.74
Credit Union Australia Limited	800,000	0.68

This is from the 2005 annual report and may be out of date by 5 months. A good thing to note is that there are no major fund names in the list such as Colonial and Commonwealth Bank. It is these fund managers which could really push the price along

Share ownership is also available as a breakdown of the number of shares owned. This is available below:

Number of shares	Shareholders
1-1,000	82
1,001 – 5,000	343
5,001 – 10,000	222
10,001 – 100,000	202
100,001 +	55
TOTAL	904

This shows the majority of owners are small individuals who own between 1000 shares ($1530) and 10,000 shares ($15300). There are also a number of shareholders in the 10,000 to 100,000 range but this is a very broad range and the majority are probably towards the lower end of the spectrum. This lets us see that there is some institutional investment but that there is also a lot of small individual shareholders.

Facts to consider:

• The top six shareholders hold more than 50% of the company
• The top ten shareholders own 73% of the company.
• The top twenty shareholders own 85% of the company.

Charting the stock

From a technical stand point (which is not the basis of this report) MOC appears to be in a long term uptrend. It has a support/resistance line at 1.54 which it continued to hit throughout the year.

It has moved roughly in line with the ASX 200 although the last short downtrend in Novemeber was not followed.

Volume on the stock has been small (pink) but large transactions have been followed by good movements.

In the short term the share appears to have spiked and will likely decline back to a manageable level on the support of $1.54

It is interesting to note that the stock has reached an all time high in the last couple of days.

Growth

Growth is analysed to determine how fast the company has grown, the sources or growth and how sustainable that growth may be. Mortgage Choice has had the following growth:

• Earnings have grown 20%
• Book Value have grown by 33%
• Revenues have grown by 7%
• Net Profit has grown by 20%
• Cash Flow Growth of 14%
• Loan Book Value increased by 23%
• Loan Life Length grown to 3.8 years from 3.5 years

These are all nice areas of Growth. Revenue Growth of only 7% shows that some cost cutting must have been in place to ensure a growth of 20% in earnings.

This growth could have come from the following places:

• Longer Life book therefore ensuring trailing commissions last longer and hold stable the company profit.
• A brand name giving it a reputation that may pull more customers.

Future Growth could come from the following:

• Increasing Market Share. Currently it is only 4.6%. This is because people are use to going to their banks to get the loan. This is slowly changing in society and Mortgage choice could pick up some more customers.
• The current market is dismal and it is not a great time the last year to be looking for property. As more houses become available, the prices may drop and/or steady and more people will come back into the market.
• People like to refinance their loans every few years to ensure they are getting the best possible deal. Mortgage choice can pick up some new customers and also grab extra trailing commissions from existing customers if they extend their loans.
• Loans are only going to get larger as the economy grows as house prices will continue to rise. This will lead to bigger loans being approved and thus longer loan life and larger trailing commission.
• This is a low capital intensive business and and the costs are scaleable which means the larger the business grows the lower the costs become as a percentage of operating revenue. For example this year the costs decreased from 25% to 23%.
• More Franchises are an area of growth. Currently there are 407 franchises. These are mainly located in NSW, VIC and QLD. There is opportunities to open some more in Tasmania (1) and Northern Territory (1). Perth and Adelaide are also growing areas and could lead the franchise growth as they only have 46 and 30 respectively.
• They are looking at Bolt-on Diversification. They are concentrating on the Commercial loans and Insurance areas. This is not the sort of growth I would like to see.

Full analysis for this company is not available as the company has only got 2 years worth of investment financials. Usually 5 years of data would give us a better picture.

Profitability
Profitability looks at the area on how much money (profit) is the company generating relative to the money which is invested into it. This is a key area as we need to invest in companies that make money and produce a return for their shareholders.

The first figure is Return on Assets. To determine ROA we do the following:

Net Profit Margin / ( Sales / Assets ) = 11.8 / (108 / 21.255) = 2.322.

Sales / Assets is the Asset Turnover.

The ROA tells us how efficient the company is turning the assets it has into money. This shows us that the company generates sales at 232%. This is explained as follows. Each Asset generates about 5 times (108 / 21.255) its values in sales. Therefore we divide the Profit by the Asset turnover and we get the return on the assets which works out to be about 232%.
This is a very large figure and shows that the company is very good at using what it has to generate a profit. In particular MOC has a very low level of capital expenditure and therefore has very little assets apart from Cash and receivables. Therefore I would say the figure is useless in the evaluation of this company and we need to look elsewhere for our analysis on profitability.

Return on Equity is an industry standard to determine how well a company is performing and how well it is in creating wealth for its shareholders.

The ROE for MOC has been outstanding. The past 2 years has shown ROEW figures of 145% and 130%. This shows the company is growing very rapidly.

There are 3 ways a company can boost its ROE figures and this needs to be investigated before the figures can be regarded as authenticate returns. The ways a company can boost their ROE figures are net margins, asset turnover and financial leverage.

Net margins for MOC are ok, and there is no financial leverage as MOC has 0 long term debt (which is great). The ROE figures are skewed a bit because of the asset turnover and the way it is structured. Still these figures are high for how it is structured and I am happy to take them as is and treat them as high ROE figures. This is because the figures have not be fiddled with by buying back shares or taking massive charges on the financial sheet.

Free Cash Flow is another measure which can give some indications into how a business is prospering. Free Cash flow is very important as this is the excess money generated by the business which is available for shareholders ( or available for the company to reinvest and expand the business ). My preference is usually for the company to give dividends as I can probably better invest the money elsewhere. Looking at the financial report shows that MOC likes to have high Payout Ratios (90%) and provides adequate dividends.

Free Cashflow is determined by Taking the Cashflow and removing the capital expenditure.

2004 Free Cash Flow = Cashflow – Capex = 10.7 – 1 = 9.7
2005 Free Cash Flow = Cashflow – Capex = 12.3 – 1.6 = 10.7

This shows that there is significant free cashflow in the business. Deteriming if this is enough free cashflow can be tricky as a guide we should aim for 5% of the sales revenue.

Free Cashflow as per Revenue = 10.7 / 108 = 9.9% which is above our 5% target.

Together we are looking for a High ROE and a High Free Cashflow figure. This company has both and is an excellent candidate for further analysis.

Financial Health

Financial health looks at the current snapshot of the company and how well a foundation it has created itself. A company needs a strong financial health to ensure it does not run into extra costs and other financial burdens which could arise in the future.

The first figure to examine is the debt to equity. In this case there is no debt which means that there is little money going into interest payments.

The second figure is times interest earned which is how many times the company could pay the interest on its debt. Again with no debt this figure is useless except in saying that the company will not have problems paying any long term debt at all. Commsec shows this figure as 10.60 which is much higher than the industry and ASX standards of 1.23 and 5.51 respectively.

The current ratio is how quickly a company could sell off assets to pay off debt. A general rule is 1.5 and MOC currently has a current ratio of 1.40. This is ok but 1.5 is the benchmark.
The quick ratio is very similar to above except it is a bit more meaningful as it removes inventories which may be sold at a price lower than they are worth. A ratio above 1.0 is a good figure and MOC is showing 1.38. This vastly improves the ability of the company to pay any liabilities and allows us to place little emphasis on the current ratio.

A last test is to ensure the company has more Assets than it does liabilities. In this case MOC has 21.255 million in current assets and 15.236 in current liabilities. There I no long term debt. This means if something drastic happened all debts could be paid and 6.01 million is available for shareholders.

Risks

This is the most important section as it has two uses. The first is it allows us to evaluate why we might not want to buy the stock at this point. The second use is as a future reference to help us evaluate when we might want to get out of the stock ( if we ever get in ).

Here are a list of Reasons / Risks on why this stock is not a great stock :

• Currently priced at a very high historical figure and is within 10% of its current high. This stock may already be overpriced.
• MOC is in a very competitive environment. It is an area of high returns and is drawing many competitors who are all trying to out do each other.
• They are currently in a dispute with franchise owners and this could cost money and divert managements attention from running the business
• Borrowers are currently moving out of the higher paying loans ( Line of credit loans ) to more traditional loans. This could reduce profit margins.
• There has been some minor management changes and whether these new managers are adequate is not fully understood.
• There is a national Broker regulation which could become standard. This could add extra costs to the business.
• A number of competitors are merging and the industry is consolidating. This means bigger competition to compete with and this could drive down profit margins.
• The lenders could reduce or change the commission structure. This would be detrimental to the business as this is where all of its money is derived.
• The housing economy could slow dramatically and people could stop taking loans for a period of time. MOC is slightly buffeted against this by its existing loan book but any dramtic slowdown will influence profits.
• This is a young company and the figures are only available for 2 years worth of data. This does not allow an adequate analysis of the company over a longer timeframe to ensure it can withstand market cycles.
• The share price is very low $1.55 and it can swing dramatically which could influence the returns significantly.
• There is some query as to the number of shares increasing dramatically each year which basically means each current shareholder is losing a % of the company they currently own. This is due to Option packages and employee purchase plans. This is a usual thing in most companies though.

This list gives us some insight into why this might not be a great stock to pick. It shows a number of reasons that the company could dramatically decline. To minimise these risks we need to invest in companies with good management who can assess the risks and ensure that they have adequate solutions.

Management

In Management is where the shareholder puts a lot of trust. They run the business and are essentially our employees. Management needs to be analysed as a bad management team can run a good business into the ground.

Areas to look at include:

• Past management performance
• Remuneration packages
• Character

The first thing to look at is how management has run the business in the past. This is hard with MOC as it has only been running 2 years but in that time it appears that management have done an excellent job. There is free cash flow available for shareholders, and they are paying out a high payout ratio.

Compensation (Remuneration packages) are sometimes a cause for concern. In this case it is a casue for concern when you read the document for “Performance Evaluation of Directors”. There is no performance incentive that ties the board to the results of the company. They are evaluated on loose fitting areas which they can/will always meet. Luckily this hasn’t been a problem yet but it is something that needs to be watched. One thing I did like was that it was tied to risk management. There are a number of risks facing the company and I am glad this at least is past of their performance reviews. Reading further suggests that their pay is not tied to the performance evaluation but is tied to policies and practices which are focused on performance and aligned with the company’s vision, values and overall objectives.
The company runs an incentive Bonus Option plan as part of its remuneration package. This is not a great idea. Yes it motivates the directors but it dilutes the stock. This dwindles away the share each shareholder has in the company as a percentage.

Character looks how honourable and trustworthy is management They have numerous charters which say how they should act and at this stage there is no blaring evidence that they are untrustworthy. The only bad sign I could see was that they changed their strategy from year to the next which was focus on the central business one year and the next was to look for bolt-on diversifications. This may have been because of the good year they had and the excess money they had but it is hard to tell. At this stage the director’s character seems ok.

Target Price and Sell Targets

I also filled out these sections on my own report but feel the math is not required to be posted here at this time. I have posted this for historical purposes for people to use and the target price to buy and sell will differ depending on what/how people have read my analysis above. Saying that MOC might still be under my target buy price ... : )

Good Luck