Australian Finance Group

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1 AUSTRALIA AFG AU Price (at 06:04, 26 Jun 2015 GMT) Outperform A$1.06 Valuation - PER A$ month target A$ month TSR % Volatility Index Low GICS sector Banks Market cap A$m day avg turnover A$m 0.6 Number shares on issue m Investment fundamentals Year end 30 Jun 2015E 2016E 2017E 2018E Revenue m EBIT m Reported profit m Adjusted profit m Gross cashflow m CFPS CFPS growth % nmf PGCFPS x EPS adj EPS adj growth % nmf PER adj x Total DPS Total div yield % Franking % nmf ROA % ROE % EV/EBITDA x Net debt/equity % P/BV x Source: FactSet, Macquarie Research, June 2015 (all figures in AUD unless noted) 1 July 2015 Macquarie Securities (Australia) Limited Strong position in the value chain A growing industry We believe there are a number of key drivers of long-term growth in the mortgage broking industry in Australia. These include: population growth, house prices, the number and value of loans outstanding, the mortgage broker penetration rate and commission rates. Each of these indicators points to continued growth (albeit at slower rates) in the mortgage broking industry over the medium term. AFG is systemically important AFG was founded in 1994 and is Australia s largest mortgage broker. AFG has a network of ~2,300 brokers and a loan book of over $100bn. AFG s growth strategy is relatively simple and based on continuing to build on the strengths of the core wholesale broking business and exploiting related niches and growth opportunities. AFG commissions have grown from $314.7m in FY12 to a forecast $499.7m in FY16e. Its balance sheet is debt free excluding securitisation-related assets and liabilities. AFG has $40.2m in cash on its pro-forma balance sheet. FY16e ROE is solid at 14.1% as is cash conversion. This will allow AFG to target a dividend payout of 70-80% of underlying earnings. Valuation Whilst there are no listed mortgage aggregators, the closest listed peer is the mortgage broking franchise, Mortgage Choice. For domestic peers, we have also chosen other companies with exposure to residential lending as well as small cap financials with similar brokerage styled businesses. On a FY16e basis these stocks trade in a range of 12-16x PER. Based on the comparables we have selected a PER based valuation range of x FY16e PER, which provides a valuation range of $ for AFG. We are therefore commencing coverage with an Outperform recommendation. Key risks The mortgage industry is subject to a range of federal and state regulations including from ASIC and APRA. In December 2014, APRA introduced macroprudential policy aimed to reduce housing market risk. While APRA did not introduce specific caps on LVRs, it did introduce thresholds on investor lending (10% YoY growth) as well as serviceability buffers (7%). AFG faces competition both from other mortgage brokers and aggregators and requires banks continuing to pursue third party distribution. Another key risk is the risk of a general downturn in the housing sector where a fall in prices, or fears of one, could lead to a fall in mortgage volumes. This would have a direct impact on AFG s business. Please refer to page 62 for important disclosures and analyst certification, or on our website

2 Inside Strong position in the value chain 3 Valuation 5 A growing industry 8 AFG is systemically important 25 Financials bear out the growth strategy 30 Key risks 36 Appendix 1 key people 38 Appendix 2 Residential market review 40 Residential market review 42 Company profile AFG was founded in 1994 and is one of Australia s largest mortgage broking groups. AFG employs approximately 170 staff members across Australia and has in excess of 2,300 AFG Member Brokers originating mortgage and loan products for their customers. AFG Brokers originate an average of approximately $4.4 billion in residential and commercial mortgage finance applications every month. This is expected to result in settlements of almost $33.0 billion in FY2015. In CY2014, AFG accounted for approximately 8.4% of the total Australian residential mortgage market, according to the MFAA Mortgage Broker Market Survey. The AFG Loan Book currently exceeds $100 billion. AFG provides its brokers with access to products, platforms, business tools and support, including a broad range of over 1,400 loan products from over 30 of Australia s leading lending and financial services institutions. Since its inception, AFG has invested over $60 million in systems and online tools to assist brokers in building their businesses. Fig 1 AFG business overview Source: AFG, July 2015 Fig 2 AFG AU vs Small Ordinaries, & rec history Note: Recommendation timeline - if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, June 2015 (all figures in AUD unless noted) 1 July

3 Key drivers point to continued growth AFG is Australia s largest mortgage broker And generates strong cash-flow and high returns Strong position in the value chain A growing industry We believe there are a number of key drivers of long-term growth in the mortgage broking industry in Australia. These include: Population growth. Macquarie Research estimates population growth will ease from current levels of 1.7% pa to ~1.4% pa driven by a normalisation in migration. House prices. Macquarie Research estimates that the peak of price growth has been seen for this cycle. Further price growth is anticipated to be driven by lower interest rates. Interest rate cuts are expected to have a smaller impact on prices than in past cycles due to the low level of existing rates, weak economic growth and lower consumer confidence. Number and value of loans outstanding. Lending commitments are currently growing at 12-13% with loans to investors growing at 22% and owner occupiers 7%. Mortgage broker penetration rate. From 20-25% in 2002, broker penetration grew to 40-45% by This has grown to 45-50% according to most recent estimates. Commission rates. Upfront commission and trail commission levels continue to recover from GFC era lows, although not yet to pre-gfc levels. Each of these indicators points to continued growth (albeit at slower rates) in the mortgage broking industry. There have been only two down years in the mortgage broking market in recent history: during the GFC in FY08 and during FY11 when the industry suffered from the pull-forward impact of the first homebuyer s grant. AFG is systemically important AFG was founded in 1994 and is Australia s largest mortgage broker. AFG has a network of ~2,300 brokers and a loan book of over $100bn. AFG s growth strategy is relatively simple and based on continuing to build on the strengths of the core wholesale broking business and exploiting related niches and growth opportunities. These are summarised below. Protect and grow the core residential mortgage broking business through continued broker recruitment and servicing; Growing the commercial mortgage broking business; Increasing the penetration of the AFG Home Loans product (white label); Leveraging AFG s technology investment; Providing additional products to the mortgage broker network; and Pursuing initiatives for growth via the on-line (web) channel. AFG commissions have grown from $314.7m in FY12 to a forecast $499.7m in FY16e. Its balance sheet is debt free excluding securitisation-related assets and liabilities. AFG has $40.2m in cash on its pro-forma balance sheet. FY16e ROE is solid at 14.1% as is cash conversion. This will allow AFG to target a dividend payout of 70-80% of underlying NPAT. 1 July

4 Valuation Whilst there are no listed Mortgage Aggregators the closest listed peer is mortgage broking franchise, Mortgage Choice. Examining the change in the Mortgage Choice share price vs. the growth in house lending commitments over the past 10 years, it is clear that Mortgage Choice s share price performance is influenced by the level of commitments. Mortgage Choice has traded over a wide range of PERs since listing. From a high of ~20x during times of recovery in the housing market to a GFC-induced low of 5.7x in June The average PER has been ~12.5x. Valuation x FY16e PER For domestic peers, we have also chosen other companies with exposure to residential lending as well as small cap financials with similar brokerage-styled businesses. On an FY16 basis these stocks trade in a range of 12-16x PER. Based on the comparables we have selected a PER based valuation range of x FY16e PER for AFG. This equates to a valuation range of $ for AFG Key risks Regulatory framework The mortgage industry is subject to a range of federal and state regulations including from ASIC and APRA. In December 2014, APRA introduced a macro-prudential policy aimed to reduce housing market risk. While APRA did not introduce specific caps on LVRs, it did introduce thresholds on investor lending as well as serviceability buffers. These included 10% growth in an institution s investor lending and a 7% serviceability assessment rate for loans. APRA also highlighted areas of lending it considered higher risk. These included: high LTV, high loan-to-income, interest-only lending to owner-occupier and long-term loans. APRA noted that ADIs undertaking a large volume of this lending could be subject to additional supervisory action. According to its May 2015 Mortgage index publication AFG s average LVR for all applications was 68.2% compared to 68.0% in April Similarly, the proportion of investor loans was 40.9%. These APRA tests are applied at the institution level, not at the AFG level, so if one institution has lending limited, it is likely to focus on another type of lending or lose market share to another lender on the AFG panel. Competition AFG faces competition both from other mortgage brokers and aggregators and from bank distribution in its own right. Whilst competition usually hurts earnings, we view AFG s high payout to brokers (Figure 48) with some comfort. We also view AFG s IT systems as a key strength in retention of member brokers. Should a bank decide to pursue third party distribution less aggressively, such as many did during the GFC, AFG s business would be impacted. This could be effected through limits on use of third party channels or changes in commission structures. Housing downturn, rise in interest rates Another key risk is the risk of a general down turn in the housing sector where a fall in prices, or fears of one, could lead to a fall in mortgage volumes. This would have a direct impact on AFG s business. A prolonged period of rising interest rates could also reduce volume growth in AFG s business. 1 July

5 Valuation Key listed peer is Mortgage Choice Whilst there are no listed Mortgage Aggregators, the closest listed peer is mortgage broking franchise, Mortgage Choice. Fig 3 Growth in house lending linked to Mortgage Choice s share price 200% 150% 100% 50% 0% Aug-05 Feb-07 Aug-08 Feb-10 Aug-11 Feb-13 Aug-14-50% -100% 40% 30% 20% 10% 0% -10% -20% -30% -40% MOC share price Lending commitments Source: IRESS, RBA, Macquarie Research, July 2015 Examining the change in the Mortgage Choice share price vs. the growth in house lending commitments over the past 10 years, it is clear that Mortgage Choice s share price performance is influenced by the level of commitments. Fig 4 Mortgage choice is trading at ~14.1x consensus PER currently Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Source: Factset, July 2015 Mortgage Choice has traded over a wide range of PER s since listing. From a high of ~20x during times of recovery in the housing market to a GFC induced low of 5.7x in June The average PER has been ~12.5x. 1 July

6 Comparative Valuation Below we undertake a comparative valuation of AFG s peers. For domestic peers, we have also chosen other companies with exposure to residential lending as well as small cap financials with similar brokerage styled businesses. Fig 5 Comparables valuation PER Dividend Yield Security Price Market Cap 2015E 2016E 2015E 2016E Mortgage Choice $2.43 $302m 14.0x 12.5x 6.5% 7.2% Austbrokers Holdings $9.20 $573m 16.3x 16.2x 4.2% 4.1% Steadfast Group $1.63 $1,208m 18.4x 15.9x 3.1% 3.9% iselect Ltd. $1.50 $392m 18.2x 16.3x 0.0% 0.8% Centrepoint Alliance $0.53 $78m Commonwealth Bank $87.29 $142,073m 15.8x 15.3x 4.8% 4.9% Westpac Bank $33.31 $105,124m 13.6x 13.2x 5.6% 5.8% National Australia Bank $34.45 $90,091m 12.8x 13.0x 5.7% 5.7% ANZ Banking Group $33.44 $92,494m 12.6x 12.0x 5.5% 5.7% Homeloans $0.58 $61m Yellow Brick Road $0.49 $135m Total/Average $432,530m 13.9x 13.6x 5.3% 5.5% Hi 18.4x 16.3x 6.5% 7.2% Low 12.6x 12.0x 0.0% 0.8% Source: FactSet, Macquarie Research, July Prices as of 26 June. Estimates based on consensus On an FY16 basis these stocks trade in a FY16 range of 12-16x PER. Based on the comparables above we have selected a PER based valuation range of x FY16e PER for AFG. Valuation range x FY16e PER We have used PER rather than other methodologies to account for the difference in stocks across the sector. The banks have on balance sheet loan books, while most of the balance of the comparables receive commissions, which makes traditional enterprise value analysis problematic. We have detailed our AFG valuation in the table below. Fig 6 AFG valuation range x FY16e NPAT Valuation FY16e Multiple- Low Multiple - High Value - Low Value - High NPAT 19.7 Total Diluted Shares on Issue Value per share $1.24 $1.42 Source: Macquarie Research, July 2015 This equates to an equity value of $266m-$305m and a per share value of $ $ July

7 As a cross-check we have prepared a DCF valuation. This is $1.35 per share and is detailed below. Fig 7 DCF valuation 2016 E 2017 E 2018 E 2019 E 2020 E 2021 E 2022 E 2023 E 2024 E 2025 E 2026 E EBITDA Cash Taxes (8.0) (9.3) (9.7) (10.8) (12.1) (12.6) (13.0) (13.4) (13.8) (14.2) (14.7) Changes in working capital (3.9) (6.0) (15.2) (16.7) (18.3) (18.9) (19.4) (20.0) (20.6) (21.2) (21.9) Changes in Provisions Capital expenditure (0.3) (0.3) (0.3) (0.4) (0.4) (0.4) (0.4) (0.4) (0.5) (0.5) (0.5) Less: Interest Tax Shield on Debt Cash Flow Growth -13.4% 9.6% 12.9% 13.1% 1.9% 3.0% 3.0% 3.0% 3.0% 3.0% Perpetual EBITDA multiple 11.0 Present Value Years Total Entity Value Less Net Debt (FY16) (40.2) Equity Value Fully Diluted Shares Price/share $1.35 WACC After tax 12.3% Source: Macquarie Research, June July

8 A growing industry Key drivers of the mortgage broking industry We believe there are a number of key drivers of long-term growth in the mortgage broking industry in Australia. These include: Population growth House prices Number and value of loans outstanding Mortgage broker penetration rate Commission rates We discuss each of these drivers below. Population growth Population growth set to continue The key long-term driver of both the housing and mortgage market in Australia is population growth. As the chart below demonstrates, this has varied from a low of 0.9% per annum in June 1993 to a peak of 2.2% in December Fig 8 Annual change in population (%) 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Source: ABS, July 2015 The two key drivers of population growth are the natural increase (births less deaths) and the net migration flow. The contribution of each of these factors to annual population growth is detailed below. Fig 9 Annual change in population (thousand, factor) Natural Increase Migration Source: ABS, July July

9 In the year to December 2014 the Australian population grew by 330,300 to 23.6m people. Macquarie Research estimates population growth will continue to ease to ~1.4% driven by a normalisation in migration. The current national average person per household ratio is 2.6, which implies new house demand of ~140,000 per annum. In addition, demolitions on an annualised basis are currently running at ~18k pa, which needs to be added to gross commencements. House price growth expected to moderate The ABS expects the number of people per household to decline to out to Population growth would result in a dwelling requirement of ~165,000 under this scenario. House prices Another key long-term driver of both the housing and mortgage market in Australia is house prices. As the chart below demonstrates, this has varied from a low of negative 4.6% per annum in March 2009 to a peak of 18.1% in March Fig 10 Australian house price index (Annual change RHS) Sep-03 Sep-05 Sep-07 Sep-09 Sep-11 Sep % 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% 8 city average price 8 city average change Source: ABS, July 2015 Macquarie Research estimates that the peak of price growth has been seen for this cycle. Further price growth is anticipated to be driven by lower interest rates. Interest rate cuts are expected to have a smaller impact on prices than in past cycles due to the low level of existing rates, weak economic growth and lower consumer confidence. A key feature of the current price cycle is the strength of the Sydney market. This is becoming a focus of both regulators and the press. This is clearly demonstrated below. Fig 11 Price levels in 4 key cities (index) Fig 12 Change in prices in 4 key cities % % Sep-03 Sep-05 Sep-07 Sep-09 Sep-11 Sep-13 Sydney Brisbane Perth Melbourne 30.0% 20.0% 10.0% 0.0% Sep-04 Sep-06 Sep-08 Sep-10 Sep-12 Sep % -20.0% Melbourne Brisbane Sydney Perth Source for Fig 10 & 11: ABS, July 2015 Another key concern is the Perth market with the impact of the mining downturn. We expect several years of subdued price growth in this market. 1 July

10 Number and value of loans outstanding Residential real estate is the largest single asset class in Australia with an estimated value of $5 trillion. Growth in its value over time is a result of the population and price growth described above. Fig 13 Household dwelling stock value ($bn) 6, , , , , , Sep-88 Sep-90 Sep-92 Sep-94 Sep-96 Sep-98 Sep-00 Sep-02 Sep-04 Sep-06 Sep-08 Sep-10 Sep-12 Sep-14 Source: RBA, July 2015 Whilst the value rarely falls, it has done so in the GFC period of 2008/09 and more mildly in late 2011 to mid This growth has in turn led to strong growth in the value of loans outstanding over time to current levels of ~$1.4 trillion. This is depicted below. Fig 14 Household dwelling loans outstanding ($bn) 1, , , , Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Owner occupier Investor Source: RBA, July 2015 Loan growth continues investors in focus A key feature of the home loan market is the increasing proportion of debt outstanding to investors. This now totals 34.6% of debt outstanding. Investor loans outstanding have been growing faster than owner occupiers loans at 10.4% in the year to April 2015 compared to 5.6% for owner occupiers. Overall the market is currently growing at 7.2%. A key indicator of profitability for the mortgage broking sector are new loans as settlements drive an upfront commission for the broker and signal the start of trail commissions. We have detailed trends in lending commitments (there are no reliable publically available settlement statistics) below. 1 July

11 Fig 15 Household lending commitments (seasonally adjusted $bn) 400, , , , , , , , Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10 Dec-12 Dec-14 Owner occupier Investor Source: ABS, July 2015 Lending commitments growing at doubledigit rates Lending commitments are currently growing at 14-15% with commitments to investors growing at 22% and owner occupiers 9%. The rate of growth is currently the subject of focus for both regulators and the media. We expect the rate of growth in investor loans to slow over time given recent regulatory moves. This is discussed more fully in the risks section later in this report. Fig 16 Change in annual household lending commitments (seasonally adjusted) 120.0% 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec % -40.0% -60.0% Owner occupier Investor Source: ABS, July 2015 The above chart highlights that annual new commitments do fall in tougher times, such as the GFC and during early We believe the 2011 downturn was caused by efforts to stimulate the economy during the GFC period. The increase in the first homebuyers grant pulled forward substantial demand into prior periods and exaggerated the recovery from the GFC. The other key factor in annual settlement volumes is the average loan life. This has varied from years in the early to mid 2000s to current levels of years. The high rate of refinancing in the mid 2000s led funders to introduce incentives to increase the life of loans. The state of the economy and interest rates also impact loan life. We have reproduced Mortgage Choice s loan life experience below, which we believe is indicative of industry trends. 1 July

12 Fig 17 Mortgage choice average loan life (existing loans - years) Source: Mortgage Choice, July 2015 Broker penetration on the rise In its most recent half year result presentation, Commonwealth Bank forecast annual Australian housing credit growth of 6-7% in FY15, % in FY16 and 5-7% in FY17. Mortgage broker penetration rate Mortgage broker penetration has generally increased over time in Australia, with a pause during the GFC. We have detailed pre-gfc penetration for mortgage brokers below. Fig 18 Broker originated loans as a proportion of new housing loans pre-gfc Source: Mortgage Choice, February July

13 From 20-25% in 2002, broker penetration grew to 40-45% by This has grown to 45-50% according to most recent estimates. We have detailed the post-gfc penetration trend below. Fig 19 Mortgage brokers share of housing market lending has been steadily growing over the past 3 years Source: Mortgage Choice, October 2013 We believe mortgage broker penetration has been increasing over time due to a number of factors. These include: One contact point for the borrower. Number and complexity of loans for the borrower to choose from. Flexibility and customisation to the borrower s needs. Provision of a distribution network for funders/banks. Commission rates on the improve Broker penetration rates have also been generally increasing in the UK and the US. UK broker penetration has grown from ~55% in 2013 to ~62% currently (source: Towergate). US broker penetration dropped from ~30% in 2008 to ~5% in 2011 before improving to current levels of 12-14% (source: Inside Mortgage Finance). Commission rates Mortgage brokers are generally paid two commissions. The first is an upfront commission on settlement of the mortgage and the second is a trail commission based on the outstanding balance of the loan. Pre-GFC, many funders paid upfront commissions of basis points. This reduced to 50 basis points during the GFC and many funders limited both the number of brokers dealt with and the volume of loans accepted. Similarly, trail commissions reduced from ~25 basis points to ~15 basis points with some lenders paying nothing in year one (source: Mortgage Choice). Commission levels have since recovered, although not yet to pre-gfc levels. The table below details the current commission rates of a range of lenders. 1 July

14 Fig 20 Examples of commission rates paid by funders Source: Mortgage Choice, July 2015 Factors such as quality, loan to valuation ratio (LVR), loan size and volume impact the maximum rate a broker can receive. It is also worth highlighting that trail commission rises the older a loan gets with many funders. The chart below highlights the recent and predicted trend in AFG s average commission rates (net of clawbacks on non-performing loans). The average trail rates below are calculated on the total trail income generation of the loan book which, due to its makeup, includes loans originated at a time when the trail commission rate was higher. Fig 21 AFG average rates (net of clawbacks) have been trending up... Source: AFG, July 2015 Similarly, Mortgage Choice s rates have also been trending up post GFC. This is demonstrated below. 1 July

15 Fig 22...As have Mortgage Choice s rates (bp) H112 FY12 H113 FY13 H114 FY14 H115 Upfront Trail Source: Mortgage Choice, July 2015 Industry growth set to continue The above factors all point to continued industry growth. This is borne out in the chart below of IBISWorld s estimate of industry revenue and medium-term forecasts. Fig 23 Estimated Mortgage Broking industry revenue ($m) 2,500 2,000 1,500 1, FY06 FY08 FY10 FY12 FY14 FY16 FY18 FY20 Source: IBISWorld, July 2015 There have been two down years in the mortgage broking market in recent history, during the GFC in FY08 and during FY11 when the industry suffered from the pull-forward impact of the first homebuyer s grant (discussed above). 1 July

16 Key players and overview There are three main functions in the mortgage industry value chain as detailed below. Fig 24 Mortgage industry value chain Source: AFG, July 2015 AFG is a wholesale broker The Australian mortgage industry is dominated by the big four banks, which account for ~78% of all lending. Mortgage brokers account for ~50% of loan origination and many also participate to various degrees in the other segments of the value chain. Within the origination segment, there are four main business models. These are detailed below. Fig 25 Four main broker business models Model Description Examples Wholesale Mortgage Broker Model Franchisor Model Licensee Model Sole Trader Source: AFG, July 2015 Wholesale mortgage brokers secure mortgage products from their lending panel and provide the support for mortgage brokers to distribute under their own name A franchisor assigns franchisees the right to market and distribute the franchisor s branded service and to use the business name for a fixed period of time Similar to the franchise model, loan writers are employed or licensed by a single branded employer, which generally pays a mix of salary and commissions to licensees The owner and broker are one and the same with no group affiliation AFG, PLAN Vow Financial, Choice Connective, FAST Mortgage Choice Aussie Home Loans Yellow Brick Road A feature of the market is that many players are fully or partly owned by funders or banks. This is detailed below. Fig 26 Many mortgage brokers have banks with ownership stakes Broker Banks with ownership stakes AFG Macquarie ~10% Aussie Home Loans Commonwealth Bank (80% stake) Choice NAB (fully owned) Connective Macquarie (25% stake) Fast NAB (fully owned) Mortgage Choice Commonwealth Bank (c17% stake) Plan NAB (fully owned) Yellow Brick Road Macquarie (~18% stake) Source: Macquarie Research, July July

17 With leading market share The industry is reasonably concentrated with the top 3 players having ~50% market share as measured by estimated FY15e revenue. This is detailed below. Fig 27 Estimated IBISWorld market share FY15e revenue Other, 27.4% AFG, 24.3% Smartline, 3.2% YBR, 3.7% Connective, 4.8% NAB, 4.8% Loan Market, 4.9% Source: IBISWorld, July 2015 Mortgage Choice, 9.7% Aussie/CBA, 17.2% This market share data is backed up by the FY14 loan books of the major brokers. This is detailed below. Fig 28 FY14 loan books of major brokers ($bn) Source: ASX releases, company web sites, press releases, ASIC, Macquarie Research estimates, July 2015 In the following sections we provide a brief overview of key companies in the sector. 1 July

18 AFG AFG was founded in 1994 and is Australia s largest mortgage broker. AFG has 170 staff and a network of ~2,300 brokers. Fig 29 AFG business overview ORIGINATION SERVICING FUNDING CUSTOMERS ~10,000 PER MONTH AFG BROKERS ~2,300 Adelaide Bank AFG Home Loans AMP ANZ Bank of China Bank of Melbourne Bank SA Bankwest BOQ AFG S LENDING PANEL (30+LENDERS) Bluestone Capital Finance CBA Citibank Deposit Power FlexiCommercial GE Money Heritage Bank HomeStart Finance AFG WHITE LABEL PRODUCTS ING Direct Keystart Home Loans La Trobe Financial Liberty Financial Macquarie Bank ME Bank MKM Capital NAB NOW Finance WHOLESALE FUNDING Advantedge NAB business line Bendigo and Adelaide Bank Pepper Homeloans Police and Nurses Rock Building Society St George Suncorp Thinktank Westpac Wide Bay Australia SECURITISATION Securities Source: AFG, July 2015 AFG s loan book is currently over $100bn. A fuller discussion of AFG s business, strategy and outlook is contained later in this report. 1 July

19 Aussie Home loans Aussie Home Loans was founded in February 1992 by current Chairman John Symond. Aussie acquired Wizard Home Loans in February 2009 for $24.0m and wholesale aggregator National Mortgage Brokers (NMB) in July 2012 for $6.6m. Aussie has a network of ~750 franchises and mobile lenders and 165 brokers in its NMB network. It had 207 employees at 30 June Commonwealth Bank s shareholding increased to 80% in 2012 and it carried its investment at $266m in June Aussie s ~$55bn 2012 loan book grew to $60.5bn by June 2014 and in December 2014 achieved a record $1.8bn in loan settlements. According to its FY14 accounts, Aussie generated total revenues of $271.1m (up 1.9% on FY13). This is detailed below. Fig 30 AHL Holdings summary financials FY13 FY14 Change Commission income % Gross profit % Margin 49.1% 40.1% Other income % Expenses % EBITDA % Margin 28.3% 18.4% D&A % EBIT % Margin 26.1% 15.4% Interest income % Interest expense % Net income % Pre-tax profit % Margin 27.2% 16.5% Tax % NPAT % Source: ASIC, July July

20 Mortgage Choice Mortgage Choice (MOC AU, $2.34, OP, TP: $2.91, Brendan Carrig) is one of Australia s leading mortgage brokers and is currently transitioning into a diversified financial services company. Mortgage Choice has three divisions: Mortgage Choice franchised mortgage broking, HelpMeChoose.com.au comparison website and Mortgage Choice Financial Planning. Mortgage Choice has a network of 412 franchises at December 2014 and 557 brokers in its network. Mortgage Choice was founded in 1992 and has a $47bn loan book and $352m in assets. The company has ~10% share of the mortgage broking market and 3.8% share of the total residential loan market. Fig 31 MOC loan book growth - 16% CAGR over time 50,000,000 45,000,000 40,000,000 35,000,000 30,000,000 25,000,000 20,000,000 15,000,000 10,000,000 5,000,000 0 Jun-01 Jun-03 Jun-05 Jun-07 Jun-09 Jun-11 Jun-13 Source: Mortgage Choice, July 2015 Mortgage Choice s continued ability to grow its core mortgage broking business drives our Outperform rating while upside potential from diversification strategies is an added bonus. For more detail on Mortgage Choice, please see our commencing coverage report, Mortgage Choice - Riding the Wave, dated 6 February July

21 Fig 32 Mortgage Choice summary financials (FY13-1H15a, 2H15 FY17e) Mortgage Choice Year Ending 30 June FY13 1H14 2H14 FY14 1H15 2H15 FY15 FY16 FY17 Outperform PER SHARE DATA Cash EPS (AUD) - Diluted Basis (cps) Current Price Target Price Cash EPS Growth (%) 2% -14% -10% -3% 13% 13% 14% 13% 8% A$2.67 $2.91 Reported EPS (AUD) - Basic Basis Total Shareholder Return 14.8% Reported EPS Growth (%) 1% -13% -10% -3% 13% 14% 14% 13% 8% DPS (AUD) Bloomberg: MOC AU BVPS (AUD) $0.84 $0.84 $0.84 $0.85 $0.85 $0.87 $0.87 $0.90 $0.92 Reuters: MOC.AX NTA per share $0.82 $0.82 $0.79 $0.81 $0.81 $0.82 $0.82 $0.83 $0.85 Shares on issue (m) Macquarie Equities Australian Banks Analyst(s) Contact(s) VALUATION METRICS Anita Stanley P/E (Cash) 17.2x 16.9x 18.8x 17.8x 16.7x 14.7x 15.6x 13.8x 12.9x Michael Wiblin P/B (Stated) 3.2x 3.2x 3.2x 3.1x 3.1x 3.1x 3.1x 3.0x 2.9x Brendan Carrig P/NTA 3.3x 3.3x 3.4x 3.3x 3.3x 3.3x 3.2x 3.2x 3.2x Andrew Wackett RoE (%) 19.7% 19.4% 17.2% 18.4% 19.5% 21.5% 20.4% 22.5% 23.8% RoA (%) 5.7% 5.7% 5.0% 5.3% 5.6% 6.2% 5.9% 6.3% 6.6% Dividend Yield (%) 4.9% 5.6% 6.0% 5.8% 5.6% 6.0% 5.8% 6.7% 7.2% Revenue growth (pp) Dividend Payout (%) 84% 94.9% 113% 103% 93.8% 88% 91% 93% 92% 16% 14% 12% 10% 8% 6% 4% 2% 0% -2% 19.0% 18.5% 18.0% 17.5% 17.0% 16.5% 16.0% 15.5% 15.0% 14.5% 14.0% FY13 FY14 FY15 FY16 Revenue growth (pp) EBITDA / Revenue (EBITDA margin) FY13 FY14 FY15 FY16 EBITDA / Revenue (EBITDA margin) EV / EBITDA FY13 FY14 FY15 FY16 EV / EBITDA PROFIT & LOSS (AUDm) Total Operating Income Total Direct Costs Gross Profit Sales Expense Other Costs Total Operating Costs EBITDA Depreciation & Amortisation EBIT Share of associates profit (gross) Pre-Tax Profit Income tax expense/benefit Share of associates profit (tax) Pro-forma NPAT Abnormal/Extraordinary items (net) IFRS NPAT Cash Adjustments Cash NPAT Minority Interests NPAT Attributable to Owners BALANCE SHEET Cash and cash equivalents Total Current assets Total Non-Current assets Total assets Total Current Liabilities Total liabilities Total shareholder equity CASH FLOW Net Income Other operating cash flows Operating Cash Flow Capital expenditure Other Investing Investing Cashflows Dividends Paid Other Financing Financing Cashflows Cash flow incr/decr in cash KEY RATIOS & GROWTH Total Revenue growth (%) -1.0% 7.0% 4.1% 14.8% 6.6% 0.9% 9.2% 6.4% 5.8% Total Cost growth (%) 3.2% 8.6% -3.5% 7.0% 16.9% -5.9% 11.5% 0.9% 4.3% Cost / Income Ratio (%) 81.2% 82.8% 85.3% 84.1% 84.6% 83.2% 83.9% 83.1% 82.9% EBITDA Margin 18.8% 17.2% 14.7% 15.9% 15.4% 16.8% 16.1% 16.9% 17.1% EBIT Margin 17.6% 16.2% 13.9% 15.0% 14.8% 16.2% 15.5% 16.3% 16.6% Source: Company data, Macquarie Research, July July

22 Loan Market Loan Market commenced trading in 1995 as Ray White Financial Services. It was founded by Sam White. Loan Market operates in Australia and New Zealand and has over 1,000 brokers. In 2012, the loan book grew to over $20bn and in July 2014 it became a Franchise business. We have detailed Loan Market s history below. Fig 33 History of Loan Market Source: Loan Market, July 2015 Advantedge (NAB) NAB is growing its white label product NAB owns three mortgage aggregators Plan, Choice and Fast. Together these three aggregators deal with ~3,500 brokers. NAB hopes to greatly extend its distribution reach through its white labelling agreement with AFG. Fig 34 NAB broker distribution structure Source: NAB, June 2014 These brands were purchased from Challenger in October 2009 for $385m. At the time Challenger claimed mortgages under management of $17.9bn and under administration of $75.3bn for a total of $93.2bn. 1 July

23 The charts below highlight that NAB had total broker volumes of $74.5bn in September 2014 and the three aggregation businesses had $21.2bn of settlements. This is detailed below. Fig 35 NAB broker volumes Fig 36 NAB aggregator settlements Source (Fig 34 & 35): NAB, October 2014 Connective Connective charges a flat fee Connective commenced business in 2003 as a wholesale aggregator. It currently deals with a network of over 2,300 brokers and at December 2014 had a loan book of over $65bn. Connective has a differentiated business model whereby it charges brokers a monthly fee rather than sharing commissions. All commissions are rebated to brokers. This has led to strong volume growth. Macquarie purchased a 25% stake in Connective in November Yellow Brick Road Yellow Brick Road (YBR) was listed on the ASX in July It operates through the 225 branch Yellow Brick Road franchise network and in August 2014 acquired Resi and Vow. Vow is an aggregator with an 809 member network and Resi is a mortgage manager and originator. YBR had a $27.6bn loan book at 31 December 2014 and generated $59.2m in revenue in H1 FY15. 1 July

24 Smartline Smartline was established in In July 2009, Smartline purchased Mortgage Force for $5.5m and in March 2012 purchased The Mortgage Gallery for $9.4m. Smartline has over 250 franchises and over 300 mortgage advisors and settles more than $5bn in home loans annually. We estimate the loan book to be approximately $20bn. According to its FY14 accounts, Smartline generated total revenues of $71.2m (up 11.2% on FY13). This is detailed below. Fig 37 Smartline Home Loans summary financials FY13 FY14 Change Commission income % Gross profit % Margin 20.5% 19.5% Other income % Expenses % EBITDA % Margin 12.1% 12.4% D&A % EBIT % Margin 11.7% 11.9% Interest income % Interest expense Net income % Pre-tax profit % Margin 12.1% 12.3% Tax % NPAT % Source: ASIC, July 2015 Homeloans Homeloans first listed in At June 2014 it had a loan book of $7.6bn, 69 staff and 72 retail representatives. Homeloans is both a broker of mortgages and a securitisation player. It generated $52.9m of revenue and $6.2m of NPAT in FY14. It is 20% owned by Macquarie and 18% by NAB. 1 July

25 AFG is systemically important Founders still involved in the business AFG was founded in 1994 by current Managing Director Brett McKeon and 3 other founding shareholders. Two of these 3 other founding shareholders remain involved with the business today. We discuss the business and key strategies below. Growth in the base AFG operates across all segments of the value chain as demonstrated below. Fig 38 AFG business overview ORIGINATION SERVICING FUNDING CUSTOMERS ~10,000 PER MONTH AFG BROKERS ~2,300 Adelaide Bank AFG Home Loans AMP ANZ Bank of China Bank of Melbourne Bank SA Bankwest BOQ AFG S LENDING PANEL (30+LENDERS) Bluestone Capital Finance CBA Citibank Deposit Power FlexiCommercial GE Money Heritage Bank HomeStart Finance AFG WHITE LABEL PRODUCTS ING Direct Keystart Home Loans La Trobe Financial Liberty Financial Macquarie Bank ME Bank MKM Capital NAB NOW Finance WHOLESALE FUNDING Advantedge NAB business line Bendigo and Adelaide Bank Pepper Homeloans Police and Nurses Rock Building Society St George Suncorp Thinktank Westpac Wide Bay Australia SECURITISATION Securities Source: AFG, July 2015 ~50% of revenue is annuity AFG generates most of its revenue in the origination phase of the value chain. This is demonstrated below. Fig 39 Revenue split and growth Source: AFG, July 2015 Origination revenue is driven by AFG s ~2,300 brokers who reach over 10,000 customers per month. Broker numbers have risen from ~ 2,000 in FY12 and revenue growth has tracked broker network growth as detailed below. AFG also services its AFG branded home loans and funds through its securitisation activities. Apart from residential mortgages, AFG brokers can also sell commercial mortgages, leases, personal loans and insurances. 1 July

26 Fig 40 Broker numbers track revenue growth. Source: AFG, July Note FY2015F based on AFG broker numbers as at March The chart below highlights that AFG has a good spread of brokers in its network by number of settlements. This is also reflected by the geographical spread of its loans book with Queensland and NSW each at 26% and AFG s home state of WA at 22%. Fig 41 Good spread of brokers in the network Source: AFG, July 2015 AFG has over 30 lenders in its lending panel, which is key to its offer to brokers. Given AFG s size and scale, it offers both a wide range of products and buying power. The big four banks accounted for 75% of settlements in FY14 as detailed below. 1 July

27 Fig 42 AFG mortgage settlements by source Source: AFG, July 2015 Strategy is uncomplicated and working Growth strategy is simple and effective AFG s growth strategy is relatively simple and based on continuing to build on the strengths of the core wholesale broking business and exploiting related niches and growth opportunities. These are summarised below. Protect and grow the core residential mortgage broking business through continued broker recruitment and servicing; Growing the commercial mortgage broking business; Increasing the penetration of the AFG Home Loans product (white label); Leveraging AFG s technology investment; Providing additional products to the mortgage broker network; and Pursuing initiatives for growth via the on-line (web) channel. In addition to the scale and buying power benefits offered to member brokers (discussed above), AFG offers member brokers comprehensive business development, sales support and the opportunity to grow into new product s with AFG. This support covers administration, IT and compliance. Business establishment and lead generation campaigns are supplied via a network of support offices and AFG s IT systems. A detailed overview of AFG s IT systems is below. Fig 43 Commercial loans are also a growth opportunity Source: AFG, July 2015 As the above chart demonstrates, commercial loan applications are forecast to grow to ~$3.1bn in FY16. This is being driven by funders, AFG and its brokers. 1 July

28 White label and securitisation White label is a key growth driver AFG Home Loans is AFG s lending business and offers AFG branded products via its lending panel. The loans are either white labelled by wholesale funding providers or securitised by AFG Securities. These loans represent a step up the value chain for AFG, enabling the capture of greater margin. AFG Securities has completed three securitisation transactions for a total of $875m. AFG manufactures this product, allowing it to keep the net interest margin. Credit risk on these loans is borne by AFG but lender recourse is limited to AFG s securitisation vehicle. AFG has two funders for its white label product: Bendigo and Adelaide and Advantedge (NAB). AFG manages the Bendigo and Adelaide loans but the NAB Edge product enables AFG to distribute on a large scale without having to invest in significant loan servicing capacity. Edge is a relatively new product for AFG and is anticipated to drive the bulk of the forecast growth in the AFG Home Loans book into FY16. This is depicted in the chart below. Fig 44 AFG Home Loans a growth driver Source: AFG, July 2015 Scale enables IT investment Scale allows large IT investment The scale of AFG s business has enabled it to invest over $60m in developing IT and broker support systems. IT is a key strategic focus for AFG to provide a high quality, reliable and innovative support system. AFG is planning on increasing innovation spend to 50% of its overall IT spend. This is being funded through reduced operations expenditure and simplification of technology and processes. AFG has two main IT systems: FLEX and SMART. FLEX is AFG s main technology platform for AFG brokers and is a single access point for all customer and lender product data. The system runs on Oracle. AFG has a 29 person technology team supported by a 29 person broker support team. Functionality includes product comparison, filters, serviceability calculators, modelling, document creation and electronic lodgement. For example, customers can sign documents directly on screen and supporting documents can be captured on an ipad camera. 1 July

29 SMART is a custom built marketing and CRM program that AFG manages on behalf of broker members. Currently 1,200 brokers are on SMART. This system manages client communications and has analytic and reporting tools. Each broker can opt in to have a personalised website, which is fully integrated into FLEX allowing for regular updates and campaign management. 1 July

30 Financials bear out the growth strategy We have detailed AFG s profit and loss in the table below. Fig 45 Profit and loss FY12(a) FY13(a) FY14(a) 1H15(a) 2H15(e) FY15(e) FY16(e) Commission Change in NPV of trails Total commission Growth 44.7% 4.0% 19.4% 17.3% 9.0% Mortgage management Securitisation fees Total sundry revenue Growth 25.1% 63.8% -26.4% -38.1% -5.2% Revenue Growth 44.5% 4.4% 18.9% 17.0% 9.0% Gross profit Margin 13.6% 12.7% 9.9% 8.9% 8.7% 8.8% 8.5% Securitisation income Securitisation expense Net Securitisation income Other income Expenses Administration Other Total Share of associates 0.0 (0.3) EBIT Margin 7.1% 5.8% 5.5% 4.9% 5.6% 5.2% 5.4% Net interest income Pre-tax profit Tax NPAT Tax rate 31.6% 32.7% 31.4% 30.8% 31.3% 31.1% 32.0% Source: AFG, Macquarie Research, July 2015 Commission growth has been strong The above table highlights the strength in commissions since FY12. This has been driven by market growth and increased commission rates from funders (refer to Figure 21). We have compared commission growth to housing commitments (system) growth in the table below. 1 July

31 Fig 46 AFG commission growth compared to system growth FY12(a) FY13(a) FY14(a) FY15(e) FY16(e) Commission Commission growth 59.6% -0.6% 21.9% 20.0% 10.1% Commitments growth 4.3% 16.4% 15.0% 12.8% n/a Source: AFG, RBA, Macquarie Research, July 2015 The table above highlights that AFG s commission income tends to grow at greater than system growth. In addition to the factors above, margins in AFG Home Loans are higher than the traditional broking book. Commission take is sustainable Another important cross check is on the sustainability of commissions. In the table below, we have compared the FY14 upfront and trail commissions to closing loan book value across the industry. Fig 47 FY14 commission to loan book value 0.500% 0.450% 0.400% 0.350% 0.300% 0.250% 0.200% 0.150% 0.100% 0.050% 0.000% Source: AFG, ASX releases, company web sites, press releases, ASIC, Macquarie Research estimates, July 2015 This highlights that AFG does not take an unreasonable level of commission from its funders. The ratio for YBR is distorted lower by the Vow and Resi acquisitions. Connective has a flat fee business model and we have no data for Loan Market. A key driver of gross margin is the payout to brokers. This is the ratio of upfront and trail commissions received from funders to upfront and trail commission paid to brokers. AFG has a high payout of ~90%, which helps attract brokers to its platform. AFG s scale and efficiency allows this level of payout. We have detailed peer payouts where available in the chart below. 1 July

32 Fig 48 FY14 commission payout to sales force 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Source: AFG, ASX releases, company web sites, press releases, ASIC, Macquarie Research estimates, July 2015 High commission payout attracts volume Connective charges a flat fee to brokers and passes all commission through to its brokers. This explains why AFG and Connective are the fastest growing companies in this space. A feature of accounting in this sector is that future trail commissions are estimated on the balance sheet at the net present value of the estimated future cash flows. The key variables are: assumed loan life ( years), discount rate (5%) and payout to brokers (85-91%). These amounts represent the vast bulk of receivables of $553.9m and payables of $543.0m on the balance sheet. The period movement in these figures is taken to the face of the profit and loss. The net impact of this adjustment is detailed in the table below. Fig 49 Underlying NPAT pre-trail IFRS adjustment FY12(a) FY13(a) FY14(a) FY15(e) FY16(e) NPAT Impact of trail book accounting Underlying NPAT Growth -7.9% 12.4% 8.3% 15.3% Source: AFG, Macquarie Research, July 2015 The above table highlights that pro-forma NPAT fell by $2.9m in FY13. Adjusting for the high level of NPV adjustment in FY12 relative to FY13, NPAT fell by $1.1m on an underlying basis. In addition to flat commissions (driven by trail assumptions detailed above), other income fell $1.6m due to high levels of sponsorship and incentive payments earned in FY12. Other expenses grew by $2.6m due to costs associated with the increased securitisation staff costs and technology fees. Apart from FY13, earnings have shown a consistent upward trend. Forecasts assume 5-7% credit growth Key assumptions for the FY16 forecast include: credit growth of 5-7%, broker market share staying at ~50%, settlements increase 10% and average loan size flat at $395, July

33 Debt free and proforma ROE > 30% We have detailed the AFG pro-forma balance sheet below. Fig 50 Pro-forma Balance Sheet at 31 December 2014 ($m) Assets Cash and cash equivalents 40.2 Restricted cash 41.6 Other financial assets 0.1 Trade and other receivables Loans and advances 1,027.6 Investments in equity accounted investees 0.0 Inventories 0.0 Property, plant and equipment 3.4 Intangible assets 0.9 Total assets 1,667.5 Liabilities Interest bearing liabilities 1,044.3 Trade and other payables Employee benefits 3.1 Current tax liabilities (0.4) Deferred income 2.5 Other financial liabilities 0.0 Deferred tax liability 11.3 Provisions 0.3 Total liabilities 1,604.1 Net assets 63.4 Equity Share capital 45.7 Reserves (0.1) Retained earnings 17.8 Total equity 63.4 Source: AFG, Macquarie Research, July 2015 Most of the large sums on the AFG balance sheet are either to do with the securitisation program or the IFRS accounting treatment of the trail book. Securitisation consists of three special purpose trusts totalling $875m and warehoused loans (i.e. loans waiting to be securitised). As discussed above, these loans are manufactured by AFG but recourse is generally limited to the securitisation vehicles. The restricted cash is associated with securitisation and not available for group use. Over 90% of the $1.0bn in loans and advances and $1.0b in interest bearing liabilities are related to the securitisation program. We have detailed AFG s debt facilities, which are all associated with the securitisation program below. Fig 51 AFG debt facilities Lender Facility Limit ($'000) (current) Drawn ($'000) (current) ANZ AFG Trust Warehouse Series No.3 255,000 80,658 NAB AFG Trust Warehouse Series No.1 400, ,228 Bondholders Secured bond issues (RMBS) 875, ,597 Source: AFG, July 2015 The other large items on the balance sheet are the receivables and payables associated with the trail book. Over 90% of the $554m in receivables and $543m in payables relate to the accounting requirement to estimate the future value of trailing commissions. This is discussed more fully in the profit and loss section above. Excluding the securitisation assets and liabilities AFG is debt free and has $40.2m in cash on its pro-forma balance sheet. Given FY16 annual operating costs of ~$40m or $3.3m per month, this is more than ample to fund working capital requirements. Given FY16e NPAT of $19.7m, FY16 ROE is forecast to be 14.1%. This is a solid ROE and compares to Mortgage Choice s FY16e ROE of 22.5%. 1 July

34 Cash conversion to enable high dividend payout We have detailed the AFG pro-forma cash flow statement below. Fig 52 Pro-forma cash flow statement ($m) FY12(a) FY13(a) FY14(a) FY15(e) FY16(e) Operating result Add (remove) non-cash items Equity accounted losses (0.3) D&A Change in working capital (1.5) Capital expenditure (1.0) (4.1) (0.7) (2.1) (0.3) Net cash flow before financing & taxation Net interest Received paid Net proceeds from / (repayment of) borrowings Proceeds from issue of shares Transaction costs Income tax paid (5.8) (8.8) (6.9) (7.2) (8.3) Net cash flow before dividends Source: AFG, Macquarie Research, July 2015 AFG is a strong cash generator with low capital requirements as the table above highlights. Most of the swings in working capital relate to the accounting treatment of the trail book and movements in the securitisation assets and liabilities. In the table below, we detail AFG s underlying NPAT to cash conversion. Fig 53 Underlying NPAT to cash conversion ($m) FY12(a) FY13(a) FY14(a) FY15(e) FY16(e) Net cash flow before dividends Capital expenditure Operating cash flow Underlying NPAT (pre trail book accounting) Cash conversion 172% 95% 199% 124% 101% Source: AFG, Macquarie Research, July 2015 This high level of cash conversion and balance sheet strength will allow AFG to target a dividend payout ratio of 70-80% of underlying NPAT. The first dividend is expected to be the FY16 interim dividend payable in April We detail below the summary financials for AFG. 1 July

35 Fig 54 AFG summary financials ($m) Interim results 1H14(a) 2H14(a) 1H15(a) 2H15(e) Profit & Loss 2014A 2015E 2016E 2017E Revenue Revenue $m EBITDA $m EBITDA $m Depreciation $m Depreciation $m Amortisation of goodwill $m Amortisation of goodwill $m EBIT $m EBIT $m Net Interest expense $m Net interest expense $m Pre-Tax Profit $m Pre-Tax Profit $m Tax Expense $m Tax Expense $m Net Profit $m Net Profit $m Outside equity interests $m Outside equity interests $m Net Abn/Extra $m Net Abnormals/Extra. $m Reported Earnings $m Reported Earnings $m Adjusted Earnings $m Adjusted Earnings $m Gross Cashflow $m Gross Cashflow $m EPS (Adj/dil) c EPS (adj/diluted) c EPS growth % EPS growth % 10.6% -3.8% 5.0% CFPS c PE (adj) x CFPS Growth % CFPS c EBITDA/Sales % CFPS Growth % EBIT/Sales % PGCFPS x Earnings Split % DPS c Revenue Growth % Yield % EBIT Growth % Franking % Profit and Loss ratios 2014A 2015E 2016E 2017E Cashflow Analysis 2014A 2015E 2016E 2017E Revenue Growth % EBIT Growth % Pre-tax Profit $m EBITDA/Sales % Depreciation & Amortisation $m EBIT/Sales % Tax Paid $m Effective tax rate % Gross cashflow $m Payout ratio % Changes in working capital $m EV/EBITA x Other $m EV/EBITDA x Operating Cashflow $m EV/Sales x Acquisitions $m Capex - Plant & Equip. $m Balance sheet ratios Asset Sales $m ROE % Other $m ROA % Investing cashflow $m ROFE % Dividend (ordinary) $m Net Debt $m Equity raised $m Net Debt/Equity % Other $m Interest Cover x nmf nmf nmf nmf Financing cashflow $m Price/NTA x NTA per share $ Net Change in cash/debt $m EFPOWA m Historical performance 2011A 2012A 2013A 2014A Balance Sheet 2014A 2015E 2016E 2017E Cash $m Revenue $m Receivables $m EBITDA $m Inventories $m Depreciation/Amortisation $m Investments $m EBIT $m Property, plant & equipment $m Net interest expense $m Intangibles $m Pre-Tax Profit $m Other Assets $m Tax Expense $m Total Assets $m Net Profit $m Payables $m Net Abn/Extra $m Short Term Debt $m Long Term Debt $m EPS (adj/dil) c Other Liabilities $m EPS growth % Total Liabilities $m Ordinary DPS c Shareholders Funds $m EBITDA/Sales % Minority Interests $m EBIT/Sales % Total Shareholders Equity $m ROE % ROFE % Total Funds employed $m 1, , , ,750.6 EFPOWA m 2014A 2015E 2016E 2017E 2014A 2015E 2016E 2017E Commissions Other revenue Total ND/EBITDA x Growth 18.9% 17.0% 9.0% 3.8% EBITDA/Net Interest x ND/Tangible assets % 53% 52% 52% Gross profit Margin 9.9% 8.8% 8.5% 8.5% EBIT Margin 4.8% 4.6% 4.8% 4.9% Source: AFG, Macquarie Research*, July 2015 *2017e Macquarie estimates 1 July

36 Key risks Regulatory framework The mortgage industry is subject to a range of federal and state regulation including from ASIC and APRA. This includes: Consumer protection laws; Privacy; Financial transaction reporting; and Money laundering. In December 2014, APRA introduced a macro-prudential policy aimed to reduce housing market risk. While APRA did not introduce specific caps on LVRs, it did introduce thresholds on investor lending as well as serviceability buffers. APRA also highlighted areas of lending it considered higher risk. This included: high LTV, high loan-to-income, interest-only lending to owner-occupier and long-term loans. APRA noted that ADIs undertaking a large volume of this lending could be subject to additional supervisory action. Fig 55 Macro Prudential Policy Focus Areas Area of Focus Strong growth in Investor lending Benchmark/ Risk Area Identified 10% YoY growth a benchmark growth above this will be considered a risk indicator Serviceability measures At least 2% above loan product rate with a minimum floor assessment rate of 7% Higher risk lending Source: APRA, Macquarie Research, July 2015 Areas that were called out include: High LTV ratios, high loan-to-income ratio, interest only lending to owner occupiers and long loan terms According to its May 2015 Mortgage index publication AFG s average LVR for all applications was 68.2% compared to 68.0% in April Similarly, the proportion of investor loans was 40.9%. We have detailed the trend in AFG s investor loans in the chart below. Fig 56 Proportion of AFG applications for investment loans 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% Source: AFG, July July

37 These APRA tests are applied at the institution level, not at the AFG level so if one institution has lending limited, it is likely to focus on another type of lending or lose market share to another lender on the AFG panel. Competition AFG faces competition both from other mortgage brokers and aggregators and from bank distribution in its own right. Whilst competition usually hurts earnings, we view AFG s high payout to brokers (Figure 48) with some comfort. We also view AFG s IT systems as a key strength in retention of member brokers. Should a bank decide to pursue third party distribution less aggressively, such as many did during the GFC, AFG s business would be impacted. This could be effected through limits on use of third party channels or changes in commission structures. Housing downturn, rise in interest rates Another key risk is the risk of a general downturn in the housing sector where a fall in prices, or fears of one, could lead to a fall in mortgage volumes. This would have a direct impact on AFG s business. A prolonged period of rising interest rates could also reduce volume growth in AFG s business. 1 July

38 Appendix 1 key people We have detailed AFG s organisational structure below. Fig 57 Organisational structure Source: AFG, July 2015 AFG s board is detailed below. Tony Gill, Non Executive Chairman. Tony was an employee of Macquarie Bank for over 16 years and was Group Head of the Banking and Securitisation Group. He is also a Past President of the Mortgage Industry Association of Australia. Brett McKeon, Managing Director. Brett is a founding director of AFG and has over 25 years of financial services experience and is a licensed finance broker. Malcolm Watkins, Executive Director. Malcolm is a founding director and has responsibility for AFG s technology, electronic delivery systems and marketing. Kevin Matthews, Non-Executive Director. Kevin is a founding director of AFG and was previously responsible for negotiating and maintaining banking and lending relationships. He was also in charge of the commercial business. John Atkins, Non-Executive Director. John is a lawyer by background and currently chairman of Lotterywest. Jim Minto, Non-Executive Director. Jim retired as CEO of TAL (formerly TOWER Australia) on 31 March He is a chartered accountant and is the chair of the Association of Superannuation Funds of Australia. Craig Carter, Non-Executive Director. Craig recently retired as Chairman of Macquarie Capital in Western Australia and has over 35 years of experience in stockbroking, capital markets and corporate finance. 1 July

39 AFG s key managers other than Brett McKeon and Malcolm Watkins are detailed below. Lisa Bevan, Company Secretary. Lisa joined AFG in 1998 as Financial Controller and was appointed company secretary in David Bailey, Chief Financial Officer. David joined AFG as CFO in 2004 and is a chartered accountant. Mark Hewitt, General Manager Sales and Operations. Mark has over 30 years of experience in financial services. Prior to joining AFG, Mark spent four years at ANZ in its third party distribution business. Jaime Vogel, Chief Information Officer. Jaime has over 20 years of IT experience including over 14 in financial services. Prior to joining AFG in 2012, Jaime was an executive at Commonwealth Bank where he was responsible for the CommSec Wholesale and Advisory Services systems and infrastructure. Chris Slater, General Manager AFG Home Loans. Chris joined AFG in 2007 as National Account Manager, moving in 2008 to State Manager for NSW and ACT, then on to Head of Sales for AFG Home Loans, AFG s own loan division, and was recently announced as the General Manager of AFG Home Loans. 1 July

40 Appendix 2 Residential market review This appendix is taken from our property team s report Listed property sector Getting closer to midnight, 29 June 2015; Residential market review The Australian residential housing market cycle has unfolded broadly in the direction that we had expected but recent price growth has been stronger than we were anticipating. Low rates and good affordability had bolstered a moderate price upswing in 2013, initially out of Sydney (after 10 years of subdued gains) before it broadened out to Perth and Melbourne and finally to Brisbane, the clear laggard in this recovery cycle. By late-2014, the stimulatory impacts from low rates have been largely realised. In 2015YTD, investors, domestically and particularly internationally, have been in the spotlight for driving house prices upwards in NSW and VIC. Indeed, we have seen continued growth in investor housing finance. Overall, further price gains are still expected for a short period of time but the rate of positive price growth is expected to moderate from here. This is particularly true for detached dwellings, given units appear to be trending down or have already fallen into price deflation across most regions (VIC/QLD/WA). The outlook for the Australian housing market shows that fundamentals are beginning to fade. Housing demand has been supported by years of undersupply but we believe this balance is shifting more to equilibrium. Migration trends continue to drive divergence between the states with growth still shifting from resource-intensive states of Western Australia and Queensland back to the larger, more diversified states of New South Wales and Victoria. Developers have lifted supply in response to strong price growth seen in the past 2 years, driving a surge in approvals and commencements, particularly for apartments. The surge in unit supply has seen Perth and Brisbane exhibit negative price growth while Melbourne appears to be trending downwards. The key takeaways for the residential market in Australia from our analysis comprise: Population growth has declined more than we had expected. While the latest population growth of ~1.4% y/y or ~330k is healthy relative to historical growth rates it is a slowdown from recent growth rates which were as high as 1.8%. We also note that this data is as at December 2014 and previous data points have been revised downwards. We expect population growth to decline further as evidenced by arrivals & departures data, GDP data, and retail sales data. Housing affordability is deteriorating in Sydney and Melbourne...remains relatively more affordable in Brisbane and Perth. Given the strong rise in house prices (e.g. Sydney +23% y/y) and only a small decline in the standard variable mortgage rate of 50bps (excluding bank discounts), housing affordability has deteriorated across a number of markets. Consistent with dwelling price movements, affordability has diverged between the states with NSW/VIC showing increasingly challenging affordability while the resources-exposed states, QLD/WA, remain relatively more affordable. Risk to interest rates still to the downside. We have seen two rate cuts in 2015 already. Our Economics team expect a further 25bp interest rate cut before the end of 2015 with the risk that further cuts could be required through 2016 if the Federal Reserve s lift off is delayed, and the pace of rate rises is even slower than the tepid pace expected. A further reduction in interest rates would obviously be supportive of an improvement in affordability. That said, our banking analysts believe the major banks are likely to re price mortgage upwards. Supply outpacing demand, but need to work through pent up demand. Building approvals are currently running at ~214,000 (last twelve months). Removing demolitions (~18k pa), we derive underlying supply of ~196,000. Comparing this to population growth of ~330k and using the ABS forecast for 2.4 people per household into the future, we derive underlying demand of ~160k houses pa (incremental people per household at 2.1). This is ~36K or ~22% in excess of underlying demand. While it appears that supply has exceeded demand, we acknowledge that there are a number of years of undersupply (ie pent up demand) that still needs to be catered for. 1 July

41 Sales turnover has provided insight into the future direction of prices with a ~3 month lead. Interestingly in Sydney, turnover has been trending down over rent months suggesting an impending moderation in price growth. Policy risk remains high. We believe regulators, government and the RBA will continue to focus on housing activity with an objective to slow down the pace of investor activity and ensure monitoring and enforcement of foreign buying. Ultimately we expect these initiatives will work to take the heat out of the market. 1 July

42 Residential market review A summary of what has happened so far price growth continues We continue to see signs of firm, price growth across a broad range of major house and unit markets with increasing divergence between the more diversified states NSW/VIC and the resources-impacted states of QLD/WA. The initial recovery in detached houses has persisted in VIC and NSW, which we understand is also supported by developers looking to restock. On the unit front, QLD/WA have continued to show price deflation while Melbourne and Sydney have set new near-term highs. Fig 58 Sydney continues to show strong price growth Monthly price data to May 2015 Last 3 months Median house prices Last 12 Since 2010 months peak Last six months Last 3 months Median unit prices Last 12 Since 2010 months peak Last six months Sydney +10% +23% +54% % +16% +41% Melbourne +6% +14% +21% % +5% +8% Brisbane +3% +3% +4% % -7% -7% Perth +0% -3% +5% % -5% +2% National (ex-darwin) +6% +13% +27% % +9% +24% Source: Macquarie Research, APM, June 2015 This cycle is still very much led by the Sydney market across both the house and unit segments where price growth levels are pushing beyond the peaks reached in 2010 (but this follows a long period of subdued gains since 2004). Melbourne has seen modest growth in house prices but unit prices appear to be showing a moderating trend as an abundance of supply comes online. Momentum in Perth has faded more noticeably, with the first few periods of negative price growth across both houses and units. Brisbane is still very much the laggard for this cycle given the sluggish domestic economy, with price falls continuing for the Brisbane unit market. Fig 59 House prices have lifted more consistently across major markets, led by Sydney and Melbourne while Perth has continue its price deflation path Fig 60 Unit prices have trended downwards but remain positive in Melbourne...Sydney is charging ahead...this series is more volatile given it is a smaller segment of the market House prices, % chg on pcp 55% 45% 35% 25% 15% 5% -5% Melbourne Brisbane Perth Sydney Unit prices, % chg on pcp 55% Melbourne Brisbane Perth Sydney 45% 35% 25% 15% 5% -5% -15% -15% Jan-94 Jan-98 Jan-02 Jan-06 Jan-10 Jan-14-25% Jan-94 Jan-98 Jan-02 Jan-06 Jan-10 Jan-14 Source: Macquarie Research, APM, June 2015 Source: Macquarie Research, APM, June July

43 Fig 61 Melbourne and Sydney have seen solid growth in detached while Perth continues price declines House prices, % chg on pcp 30% Melbourne Brisbane Perth Sydney 25% 20% 15% 10% 5% 0% -5% -10% -15% Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Fig 62 Melbourne and Sydney surged ahead amid increased investor activity Unit prices, % chg on pcp 25% 20% 15% 10% 5% 0% -5% -10% Melbourne Brisbane Perth Sydney -15% Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Source: Macquarie Research, APM, June 2015 Source: Macquarie Research, APM, June 2015 Price to income ratios: The price to income ratio in residential property assesses household incomes against dwelling assets. The measure has typically been range bound, averaging 2.8x for the period and increasing to 4.4x following June This highlights the increasing spread between dwelling prices and household incomes, indirectly suggesting that residential dwellings have becoming more affordable from a serviceability perspective in light of the lower interest rate environment. Fig 63 Price to income ratio largely range bound since 2003 Fig 64 Price rises are decelerating across a number of capital cities Ratio RBA proxy measure Post Jun-03 average: 4.4x Decelerating Price Rises (21 months) Peak Accelererating Price Falls (4 months) Decelerating Price Falls (4 months) Trough average: 2.8x 2.0 Jun-88 Jun-93 Jun-98 Jun-03 Jun-08 Jun-13 Accelerating Price Rises (30 months) Source: RBA, ABS, Macquarie Research, June 2015 Source: Macquarie Research, APM, June 2015 Previous Cycles: In light of ~24 months of above average price growth since 2013, the first in four years admittedly, there are already market concerns about the longevity of this upswing cycle. In this context, it is useful to compare the relative progress of past housing cycles. The duration of prior cycles has stretched to around five years, with 30 months of accelerating annual price growth, 21 months of decelerating annual price growth, before an eight month downturn, on average. While the last six months have shown stronger price growth than we were expecting, we believe we are closer to the peak of the house price cycle. A cyclical peak in annual price growth in late 2015 would suggest a decline phase from Certainly, every cycle is different and the timing and extent of that eventual rate tightening cycle would be the critical determining factor for when the pricing upswing ends. However, history suggests that this moderation phase can take some time nearly two years to unfold. 1 July

44 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Macquarie Wealth Management Near-term activity indicators point towards more growth High frequency housing market indicators continue to provide reasonably healthy readings for near-term sales activity and pricing momentum (charts below). Looking at history, the relationship between auction clearance rates (adjusted for withdrawals) and dwelling (house and unit) prices remains strongly robust in bigger, more liquid markets like Sydney and Melbourne, with smoothed auction clearances typically running ahead of annual price growth by around three to four months. Recent readings for adjusted auction clearances in Sydney are at all-time highs of 82% and 85% for houses and units respectively. Melbourne is at 80% and 69% for houses and units respectively, suggesting room for further price growth in the short term. Fig 65 Sydney house auction clearance rates are at all time highs Fig 66 Sydney unit auction clearance rates showing a similar trend while prices surge ahead % 25% 20% 15% 10% 5% 0% -5% -10% 90% 80% 70% 60% 50% 40% 30% % 20% 15% 10% 5% 0% -5% -10% 90% 80% 70% 60% 50% 40% 30% Sydney House Median Prices (LHS) Sydney House Clearance Rates (RHS) Sydney Unit Median Prices (LHS) Sydney Unit Clearance Rates (RHS) Fig 67 Melbourne house auction clearance rates are tracking ahead of price growth... Fig 68...which is consistent across Melbourne unit auction clearance rates % 30% 25% 20% 15% 10% 5% 0% -5% -10% 90% 80% 70% 60% 50% 40% 30% % 25% 20% 15% 10% 5% 0% -5% -10% 90% 80% 70% 60% 50% 40% 30% Melbourne House Median Prices (LHS) Melbourne House Clearance Rates (RHS) Notes: Clearance rates are a moving 3-month average Source: Macquarie Research, APM, June 2015 Melbourne Unit Median Prices (LHS) Melbourne Unit Clearance Rates (RHS) Notes: Clearance rates are a moving 3-month average Source: Macquarie Research, APM, June 2015 That said, sales turnover has also provided insight into the future direction of prices with a ~3 month lead. Interestingly in Sydney, turnover has been trending down over rent months suggesting an impending moderation in price growth. 1 July

45 Fig 69 Volumes lead price growth by 3 months %ch pa 25% 20% 15% 10% 5% 0% -5% -10% 4,000 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15 Sydney Dwelling Prices (LHS) Sydney Sales Volume (RHS) Notes: Turnover is a 12-month rolling average Source: Macquarie Research, ABS, June ,000 12,000 10,000 8,000 6,000 Price boost from lower rates is fading More so than most other developed markets, prices and activity in Australian housing are extremely sensitive to changes in mortgage interest rates. Broadly, 90% of new occupier housing loans in the past year are floating rate linked to the short cash end of the curve. Changes to the official cash rates are typically reflected in the variable mortgage rate and therefore benefit actual household mortgage repayments for new loans even if the lock-step moves between cash and mortgage rates have loosened since the Global Financial Crisis. In all, the Australian housing market cycle is typically a lagged reflection of the mortgage interest rate cycle a relationship that continues to drive the housing market this time, just as it has done in all previous cycles. Looking through prior Australian housing market cycles over the past 25 years, there is a consistent and reliable pattern of mortgage rate cycles driving the housing price cycle. Increases in mortgage repayments of around 20% in a year mortgage rates rising from say 5% to 6% - will weaken the housing market sufficiently to create price falls. Similarly, lower mortgage repayments more loosely at around -10% to - 15% a year, are typically enough to stabilise the market and drive a return to capital gains. Interestingly, we can see that from previous cycles, strong price gains (exceeding 10% per annum) can persist deep into the mortgage tightening cycle (as indicated in the three circled periods in the chart on the RHS below). Fig 70 Despite elevated spreads on cash, mortgage rates are sitting at their historical lows, with the prospect for further cuts % Jan-94 Jan-99 Jan-04 Jan-09 Jan-14 Margin over cash Official Cash Rate Variable Mortgage Rate 20-Yr Average Fig 71 The decline in mortgage rates has continued after the RBA s interest rate cuts this year a decline in mortgage rates can be supportive for further dwelling price gains % VMR Change 40% Consequentive quarters of price falls (<0%) 30% Consequentive quarters of price gains (>10%) 20% 10% 0% -10% -20% -30% -40% -50% Jan-91 Jan-95 Jan-99 Jan-03 Jan-07 Jan-11 Jan-15 Source: Macquarie Research, RBA, June 2015 Source: Macquarie Research, ABS, RBA, June 2015 As indicated in the chart above (LHS), the cash rate and standard variable mortgage rate in Australia have declined to 2.0% and 5.45% respectively. Despite this, we note that there has been enhanced competition from the banks to offer discounted variable and fixed rates in the last year, which has led to lower borrowing rates in the market in general. 1 July

46 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Macquarie Wealth Management Risk to interest rates still to the downside. We have seen two rate cuts in 2015 already. Our Economics team expect a further 25bp interest rate cut before the end of 2015 with the risk that further cuts could be required through 2016 if the Federal Reserve s lift off is delayed, and the pace of rate rises is even slower than the tepid pace expected. A further reduction in interest rates would obviously be supportive of an improvement in affordability Assuming the banks pass on the expected cash rate reduction in total, we forecast a ~130bps reduction in the proportion of household income allocated to a mortgage in Sydney. Housing affordability eroding with higher prices In our analysis of housing market cycles, we rely on a derived measure of household affordability for each capital city, made up of household incomes, house and unit prices and mortgage rates. Importantly, this assesses housing affordability in the same way that bank lenders assess capacity to pay with regard to mortgage interest rates something that is absent from simpler measures like price-to-income and price-to-rent ratios. Indeed, this is traditionally the most telling signal of whether pricing in a specific market is overstretched in both absolute and relative terms, by highlighting the historical constraints on household borrowing. As mortgage rates were cut to their historical lows since late 2011, housing affordability consistently improved across all housing markets to their best levels for many years. With the subsequent rebound in prices partly offset by modest income growth that housing affordability is starting to turn clearly, notably more so in markets like Sydney where price gains are the strongest as evidenced in the charts further above. Even as that housing affordability starts to deteriorate again for this cycle, it is yet to return to the historical levels that preceded pricing downturns (notably Sydney in 2004, Perth in 2006 and more broadly in 2008 and 2011). That said, affordability will continue to weaken in coming months as prices lift further, although this may be partially offset by further interest rate reductions. Sydney has begun to emerge as the least affordable city this cycle, driven by increasing prices. Sydney affordability: A natural extension of housing affordability is the level of house price growth required to reach the previous peak in affordability. In Sydney, we estimate that there is a further ~210bp in dwelling price growth required before household affordability reaches the prior peak of 59% last seen in In our analysis, we assume a 2.5% growth in household income (from the FY13-14 state-level national accounts data) and include the latest movement of 20bps decline in variable mortgage rates (ie. the banks did not pass on the full 25bp cut). Fig 72 Housing affordability is starting to weaken due to higher prices, a process very much led by Sydney this cycle Brisbane still expected to be late this cycle 70% 60% Sydney Melbourne Brisbane Perth Less affordable 50% 40% 30% More affordable 20% Source: Macquarie Research, ABS, June July

47 Mar-83 Mar-86 Mar-89 Mar-92 Mar-95 Mar-98 Mar-01 Mar-04 Mar-07 Mar-10 Mar-13 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06 Mar-09 Mar-12 Macquarie Wealth Management Firm migration sustaining housing demand but it s peaked The drivers of housing demand are varied, but most of these birth rates, household formation rates, and purchaser preferences are slow moving at best. For example, the reintroduction of the baby bonus in 2004 did have a measurable impact on births and even population growth, but the aggregate impacts on housing demand are modest especially compared to other, more variable drivers. After a stellar run up, there are some early signs of moderation in net overseas migration, with the latest figures easing slightly back to an annual pace of ~184k, down ~29% from its late 2012 peak. That said, the pace of migration remains high by historical standards, being ~35% above the 30-year trend of ~136,000. These firm levels of net overseas migration continue to be the dominant driver of demand (chart below, LHS), as newly arrived immigrants tend to have more urgent housing needs than other forms of population growth, such as a new births. The moderation in migration becomes more acutely apparent at the regional level. Net migration the combination of overseas and interstate flows continues to be strong in New South Wales and Victoria (chart below, RHS), mainly through buoyant foreign immigration. Interstate emigration is still limited, but that might change if that gap in relative affordability between Sydney/Melbourne and other regions continues to diverge. As the mining investment cycle unwinds, both foreign and interstate migration into Western Australia and Queensland is slowing significantly a trend that has been reducing housing demand in these regions. Fig 73 Net migration now easing more visibly (latest data available to December) Fig 74 By region, the reduction in immigration is most apparent in WA and QLD and partly reflects the slowing mining sector Fig 75 Population growth has been revised down compared to the numbers implied by the retail sales data '000 annual '000 annual Mar-83 Mar-88 Mar-93 Mar-98 Mar-03 Mar-08 Mar-13 Births and Deaths Net Migration NSW VIC QLD WA % 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Sep-01 Sep-04 Sep-07 Sep-10 Sep-13 Retail sales data Population data Source: Macquarie Research, ABS, June 2015 Source: Macquarie Research, ABS, June 2015 Source: Macquarie Research, ABS, June 2015 Population growth has declined more than we had expected. While the latest population growth of ~1.4% y/y or ~330k is relatively healthy, we note that this data is as at December 2014 and previous data points have been revised downwards. We expect population growth to decline further. Indeed, this view is consistent with ABS projections for a moderation of population growth as indicated in the chart below (RHS). Fig 76 Population growth moderation driven by slowing migration Fig 77 Forecast population growth expected to trend downwards % Chg pa 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% % 2.30% 2.00% 1.70% 1.40% 1.10% 0.80% 0.50% Births and Deaths Net Migration Total Jan-10 Jan-15 Jan-20 Jan-25 Jan-30 Jan-35 Forecast Actual Source: Macquarie Research, ABS, June 2015 Source: Macquarie Research, ABS, June July

48 Jan-96 Jan-99 Jan-02 Jan-05 Jan-08 Jan-11 Jan-14 Macquarie Wealth Management Looking at recent trends by state. Growth rates have improved in the last 3 years in NSW/VIC while the resources-heavy states, QLD and WA continue to show population growth moderation as the mining boom continues to subside. Fig 78 Population growth trends have moderated slightly particularly in WA % chg y/y 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Jun-81 Jun-86 Jun-91 Jun-96 Jun-01 Jun-06 Jun-11 NSW VIC QLD WA AUS Source: Macquarie Research, ABS, June 2015 Consumer sentiment was buoyed by a temporary spike following the federal budget. The consumer sentiment index rose markedly to in May from 96.2 in April, the highest level since January 2014 following a federal budget that was aimed at improving consumer sentiment. For more details, see: Listed Property Sector - Budging on the budget. Fig 79 Unemployment trends remain challenging despite the most recent reading being a very positive result Fig 80 Consumer sentiment trend remains soft despite a temporary positive spike following the Federal budget AUS Index Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 NSW VIC QLD WA AUS Source: Macquarie Research, ABS, June 2015 Source: Macquarie Research, ABS, June 2015 Unemployment bucked the negative trend at its May reading a resumption of the negative trend would potentially provoke policy response. The unemployment rate has been showing a declining trend in 2015 YTD having declined ~13bps in NSW, ~42bps in VIC, ~20bps in QLD, ~82bps in WA and ~10bps across the country. Despite recent reductions in the unemployment rate, our economics team are of the view that unemployment will increase from here. Furthermore, there appears to be a positive relationship between unemployment and house price growth. That is, as unemployment increases, house prices tend to increase as well. We believe rising unemployment attracts a looser monetary policy response which supports house price growth. Indeed, this was seen in the 1990s recession where unemployment increased from 8.9% to 10.7% and house prices rose ~8% nationally. Similar scenarios were seen in the post GFC period and the QE periods more recently. 1 July

49 Fig 81 Positive relationship between unemployment and house prices Housing market cycle (and variable mortgage rate easing cycle/timeframe) Mortgage rate cycle (reaching -10% threshold) Change in house prices 1 (12 months prior) Change in house prices 1 (12 months later) Unemploymen t rate shift (over 12 month period) 1987 cycle (-150 bps over 6 months) 4Q % +44% 7.3% to 6.6% 1990 recession (-200 bps over 9 months) 4Q % +8% 8.9% to 10.7% Mid 90s cycle (-125 bps over 6 months) 3Q % +11% 8.3% to 8.2% Tech bust (-100 bps over 12 months) 2Q % +21% 6.5% to 6.4% Post GFC (-260 bps over 6 months) 4Q % +13% 4.5% to 5.7% Post GFC quantitative easing (185bps over 24 months) 4Q % +8% 5.2% to 5.8% Notes: 1. Weighted average for 8 capital cities Source: Macquarie Research, ABS, APM, June 2015 Supply has seen a positive kick up ahead of underlying demand Looking at the recent history of housing approvals and starts in Australia, activity has been very much range-bound over an extended period (without the outsized oversupply seen in Spain and the US for instance). Moreover, prior supply cycles were very much linked (with some lags) to corresponding cycles in both mortgage interest rates and house prices. Fig 82 Building approvals at record highs, suggesting an even firmer pace of housing starts into 2H15 and 2016 '000 annual Sep-91 Sep-94 Sep-97 Sep-00 Sep-03 Sep-06 Sep-09 Sep-12 Approvals Commencements Completions Source: Macquarie Research, ABS, June 2015 On a national basis, the latest building approval figures are at a record high of ~214k (annualised). This suggests that there will be further growth in commencements into 2H15 and Housing supply peaked at an average of ~182k per annum in previous cycles. Interestingly, completions in CY14 were ~173k, which implies that there is still ~41k of new stock coming (assuming 100% approvals begin construction and are completed). Fig 83 Building approvals are surging ahead in NSW and VIC with some signs of growth in QLD while WA declined monthly 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Enhanced FHOS 0 Jul-83 Jul-88 Jul-93 Jul-98 Jul-03 Jul-08 Jul-13 NSW VIC QLD WA Fig 84 Implied cancellations typically provide a ~36 month leading indicator to price moderations % 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Jun-94 Jun-97 Jun-00 Jun-03 Jun-06 Jun-09 Jun-12 Implied Cancellations (LHS) House Price Index Growth (RHS) 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% Source: Macquarie Research, ABS, June 2015 Source: Macquarie Research, ABS, June July

50 After a period of subdued housing supply since 2011, the combination of lower mortgage rates and recovering house prices stirred the residential construction market back into action from Initially, the recovery had been slow but quickly rose, primarily due to strong apartment/unit growth. Moreover, activity was relatively concentrated in VIC (specifically Melbourne) and NSW (Sydney) rather than other major capital cities. The more recent surge in construction activity in 2015 YTD included markets like Brisbane. Brisbane and Sydney are markets that had not seen meaningful supply additions for some years. Implied cancellations have led residential dwelling prices by ~36 months in the last 10 years. They represent the difference between commencements and completions. In prior cycles, implied cancellations have peaked at 10% towards the latter end of a housing cycle (refer chart above on RHS). We note that there is typically a 9-15 month lag between commencement and completion for detached dwellings (24-36q months for multiunit/apartments) which can produce negative implied cancellations (completions exceeding commencements in a period). Fig 85 This construction cycle has been driven by units/apartments, but detached houses have also turned the corner '000 monthly 14,000 12,000 10,000 8,000 Enhanced FHOS 6,000 4, % of Total 2, % of Total 0 Jul-83 Jul-88 Jul-93 Jul-98 Jul-03 Jul-08 Jul-13 Private Houses Private Units/Townhouses Public 54.1% of Total Fig 86 NSW had ~22k units completed while VIC had ~24k units completed in CY14 '000s NSW VIC QLD SA NT TAS WA ACT Houses 2 Units 6 3 Source: Macquarie Research, ABS, June 2015 Source: Macquarie Research, ABS, June 2015 Completions were driven by units in NSW and VIC, which now represent 52% and 44% of all stock completed in 2014, as shown in the chart below. This compares to the 20-year averages of 46% and 27% respectively. Fig 87 Share of unit completions has increased over the last 20 years % 60% 50% 40% 52% 44% 30% 20% 10% 0% Jun-85 Jun-89 Jun-93 Jun-97 Jun-01 Jun-05 Jun-09 Jun-13 NSW VIC Source: ABS, Macquarie Research, June July

51 Matching supply with demand As fundamentalists, we use demand and supply to estimate where the underlying balance of the residential market sits at the moment. Our definitions of underlying demand and underlying supply are adjusted by a number of factors. Underlying demand: Population growth divided by people per household. People per household is driven by net housing stock additions (underlying supply, described below) and population growth, as well as consumer preferences. Underlying supply: Completions less demolitions. We typically use annual figures which are derived as the sum of the last four quarters. The ABS expects the number of people per household to decline to 2.4 by 2031 (2.5 at last census). Statistically, this means that any incremental demand would be at ~2.1 people/household over the next 26 years in order to bring the number national average number of people per household down from 2.5 to 2.4. Combining this with population growth of ~330k per annum (run-rate of latest population data, December 2014) would result in annualised underlying demand of ~160k. This is significantly below current annualised housing approvals of ~214k. In addition, demolitions on an annualised basis are currently running at ~18k pa which derives underlying supply of 196k per annum, but remains above underlying demand. Fig 88 Current approvals (supply) materially outstrips declining demand Indicator (per annum) Units Value Population growth 000's 330 People per household current # 2.50 People per household - projected # 2.40 People per household - incremental demand # 2.06 Underlying demand 000's 160 Current approvals 000's 214 Demolitions 000's 18 Underlying supply 000's 196 Over/(under)-supply 000's 36 Over/(under)-supply % 22% Source: ABS, RBA, Macquarie Research, June 2015 We assess the level of oversupply while adjusting our assumption for the incremental number of people per household. We also consider a number of scenarios with different annualised demolition rates (which, arguably, should increase over time due to a greater inventory of housing stock). At the lowest level of people per household and the highest rate of demolitions, there still remains an oversupply of ~22k dwellings or 13% of underlying demand. Fig 89 Oversupply of 22.2k dwellings using our more conservative assumptions Incremental demand - people per household Fig 90 Supply exceeds demand by 13% using our more conservative assumptions Incremental demand - people per household Demolitions ( 000s) Demolitions ( 000s) 15 21% 27% 33% 39% 45% 51% 57% 18 19% 25% 31% 37% 43% 49% 55% 21 17% 23% 29% 35% 41% 46% 52% 24 15% 21% 27% 33% 38% 44% 50% 27 13% 19% 25% 30% 36% 42% 48% Source: Macquarie Research, ABS, June 2015 Source: Macquarie Research, ABS, June 2015 Demand-supply balance: We overlay our derived underlying demand and derived underlying supply over time which provides us with an indication of the level of excess demand/supply in the market (refer chart below on LHS). The demand-supply curve over time shows two periods of strong excess demand in the last ~10 years (pre-gfc in and 2012 to 2014). We observe a 12-month lag between the demand-supply balance and dwelling price growth. We highlight that the demand-supply balance appears to be equalising in the last quarter of We acknowledge however, that this analysis does not factor in existing dwelling stock and therefore the opening level of excess demand (or supply). 1 July

52 Fig 91 Supply has ticked upwards with more unit completions...demand falls on weaker migration trends but remains marginally ahead of supply Fig 92 The demand-supply balance typically leads dwelling price growth by months...rate of excess demand is slowing and appears to be trending to oversupply '000 annual '000 annual 100 Excess Demand 50 20% 15% 10% 5% Jun-88 Jun-93 Jun-98 Jun-03 Jun-08 Jun-13 Underlying Demand Underlying supply 0 0% -5% -50 Excess Supply -10% Mar-03 Mar-05 Mar-07 Mar-09 Mar-11 Mar-13 Mar-15 Demand/Supply Balance (LHS) Dwelling Price Growth (RHS) Source: Macquarie Research, ABS, June 2015 Source: Macquarie Research, ABS, June 2015 Regionally: In 2014, NSW screens as the only state in excess demand while all the other states were in oversupply. Notably, NSW was in excess demand on both an absolute and relative to existing dwelling stock basis. This is consistent with the above-market dwelling price growth we have seen in NSW. NSW is currently in excess demand of 7,431 dwellings (0.3% of existing stock) while WA is the worst at 7,112 oversupply (0.6% of existing stock). Note that for demolitions and people per household, we have used our forecast rates on a national level and extrapolated them on the state level. Fig 93 NSW is the only state in excess demand with WA in the greatest oversupply...consistent with price trends Fig 94 NSW continues to be the most solid when measured relative to existing stock... '000 annual Demand-supply balance (2) (4) (6) (8) NSW QLD TAS ACT NT SA VIC WA % 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% -2.5% -3.0% -3.5% -4.0% 0.3% -0.1% -0.2% -0.3% -0.6% -0.8% -0.9% -3.5% NSW QLD VIC SA WA ACT TAS NT Notes: 1. Demand is population growth by state divided by projected national ratio of people per household. 2. Supply is completions less national % of stock demolitions in the state. Source: Macquarie Research, ABS, June 2015 Notes: 1. Demand is population growth by state divided by projected national ratio of people per household. 2. Supply is completions less national % of stock demolitions in the state. Source: Macquarie Research, ABS, June 2015 Housing finance growth likely to ease Historically, there is a robust (and inverse) relationship between mortgage rates and the value of housing finance. This is rather intuitive, as households often borrow as much as they are capable of and comfortable servicing, given their equity contribution. While the recovery in housing finance lagged in 2012, the pace of lending growth gained momentum in late 2014 but has gradually declined back into negative territory in 1H15. This was expected in 2014 given there were no rate cuts since August We expect housing finance to exhibit some positive reversion as there will be support from the effects of the February 2015 and May 2015 rate cuts. 1 July

53 To date, the reported recovery in housing finance has been very lop-sided. By segment, the key trend is the firm upswing for both investors and repeat buyers, while first home buyers lag dramatically. Whether low participation from first-time buyers reflects pricing-out or survey mis-measurement is still not clearly determined, but it is likely that the measured number of first home buyers will remain low this cycle, in the absence of a return to the enhanced first home owner grant (and its adverse consequences in artificially inflating the broader market). Fig 95 Lending growth expected to show some positive reversion following the RBA rate cuts Fig 96 Housing finance data shows strong gains in the investor and repeat buyer segments, with first-time buyers well lagging % Jan-91 Jan-96 Jan-01 Jan-06 Jan-11 Housing finance, numbers, ex-refi (LHS) Source: Macquarie Research, ABS, RBA, June 2015 Source: Macquarie Research, ABS, June Mortgage Rates, inverted (RHS) $bn, monthly Enhanced FHOS 0.0 Jan-90 Jan-94 Jan-98 Jan-02 Jan-06 Jan-10 Jan-14 First Home Buyer Investors Repeat Buyers Looking ahead, we expect the robust linkage between mortgage rates, mortgage borrowing and housing affordability to hold. We believe there is likely some positive support for lending growth in the short term as per our Economist s forecast for a further 25bps cut to the official cash rate by end of Following that, gradual moderation is expected, at least until a genuine rate tightening cycle, which will markedly constrain lending growth (as well as price inflation and sales activity levels more broadly). It is clear that investor lending has had distortive impacts on the Australian residential market. As indicated in the below chart, investor lending growth has outpaced owner occupier lending considerably, particularly in NSW. Fig 97 Growth in investor loans has outpaced owner-occupier over the last 5 years, particularly in NSW Fig 98...currently growing at ~10.4% y-y, 40bps above the threshold suggested for the major banks by APRA in December 2014 % APRA Threshold (10%) 10.4% % Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Rolling 12-mth change on pcp Month change on pcp Source: ABS, RBA, Macquarie Research, June 2015 Source: RBA, Macquarie Research, June July

54 Foreign buyers are in the spotlight...who will strike first? The main distortive factor that has been at play in the residential market is the impact of foreign buyers. Obtaining reliable data on the level of foreign buying in the Australian market has proven difficult. We highlight the distinction between foreign buyers in the market and foreign developers. Foreign buyers: Non-residents or temporary residents looking to purchase either new or established residential dwellings in Australia. Foreign buyers have an impact on the demand side only. Our analysis focuses on the activities of foreign buyers and their impact on demand. Furthermore, we specifically focus on the buyers who are purchasing for owner-occupied or investment purposes (not re-development). Foreign developers: Non-domestically domiciled entities (including people and corporations) that are looking to purchase or acquire dwellings or locations with the purpose of developing residential dwellings at the site. Foreign developers have a short term impact on demand (restocking, potentially at higher prices) but a medium to long-term impact on supply (introduction of new stock). Foreign buyers are further divided into temporary residents and non-residents. Only temporary residents can purchase one (only) existing dwelling but must be used as their principal place of residence and not generate any rental income. This implies that nonresidents are typically investors. Fig 99 Foreign investors can only purchase new dwellings Dwelling type New Established Temporary residents Yes Yes, one only Non-residents Yes No Source: FIRB, Macquarie Research, June 2015 According to FIRB statistics, there was $34.7bn proposed investments by foreign buyers into residential property in FY14, 102% higher than the $17.2bn during FY13. This was driven largely by growth in new properties, which were up 199% to $25.9bn, from $8.6bn. Residential real estate proposals approved were up 98% to 23,054 from 11,668. Similarly, we note that this was driven by the number of proposals for new residential properties, which was up 221% to 14,591 from 4,549. This suggests that there is a greater percentage of activity from foreign investors. Moreover, our industry feedback points towards much of this investment being concentrated in the Melbourne and Sydney markets. Fig 100 Foreign investment into new dwellings doubled when measured by value and number of approvals Approved proposals Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13 Jun-14 Growth (%) By value Existing $bn % New $bn % Other $bn % Residential $bn % By number Existing # 2,986 4,015 2, ,881 3,952 5,091 7,915 55% New # 1,076 1,367 1,189 1,959 3,976 4,092 4,549 14, % Other # 1,452 1,789 1,076 1,117 1,699 1,724 2, % Residential # 5,514 7,171 4,715 3,723 9,556 9,768 11,668 23,054 98% Source: FIRB, Macquarie Research, June 2015 The chart below illustrates that foreign buyer activity in the resi market has increased relative to history but remains a relatively small proportion of the overall turnover in Australia. Foreign buyers constitute 15.5% of Australian housing turnover when measured by value and only 4.9% when measured by number of transactions. We compare residential turnover in Australia against FIRB approved proposals overtime in order to gauge involvement of foreign buyers in the residential market. Residential turnover by value is a derivative of median turnover prices and number of dwellings transacted. 1 July

55 Fig 101 Share of foreign buyers in the Australian market not as high as expected # 20.0% 16.0% 15.5% 12.0% 8.0% 4.0% 4.9% 0.0% Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 By Number By Value Source: FIRB, ABS, Macquarie Research, June 2015 We acknowledge that one of the major shortcomings of this approach is the fact that there may be foreign investors who are purchasing residential dwellings through third parties, illegitimate methods, local citizens/residents or other means. As such, this activity would not be recognised through FIRB s data. Indeed, this is one of the key residential themes to have received a lot of commentary from various industry bodies including APRA, ASIC, the RBA and the state and federal governments. We table the developments on the foreign investor front in the table overleaf, which includes macro-prudential policies aimed at domestic investor lending as well. Policy risk rising The housing market is one of the most heavily observed markets in Australia, particularly from a regulatory standpoint. We highlight that the first home owners grant still remains in effect in a few states. This continues to provide a tailwind for housing prices. Having said that, we believe the federal and state governments are likely to maintain the grant given rising concerns of housing affordability for first home buyers (owner-occupiers). The first home owners grant only applies to new properties or developments given focus on creating new supply. Indeed, the Western Australian state government has said that it intends to remove the first home owners grant for existing properties at its state budget but has yet to be legislated. 1 July

56 Fig 102 First Home Owner Grant (FHOG) is targeted towards new properties 22/06/2015 Jan 12 to June 12 July 12 to Dec 12 Jan 13 to Jun 13 Jul 13 to Dec 13 Jan 14 to Jun 14 Jul 14 to Dec 14 Jan 15 to Jun 15 Jul 15 to Dec 15 Jan 16 onwards NSW VIC QLD WA New homes Existing homes New homes Existing homes New homes Existing homes New homes Existing homes Total potential entitlement $ 17,000 32,000 25,000 25,000 25,000 25,000 15,000 15,000 10,000 Federal first home owner grant $ 7,000 7,000 Federal boost $ State supplement $ - 15,000 15,000 15,000 15,000 15,000 15,000 15,000 10,000 Regional bonus $ 10,000 10,000 10,000 10,000 10,000 10,000 Total potential entitlement $ 17,000 17,000 10,000 10,000 10,000 10, Federal first home owner grant $ 7,000 7,000 - Federal boost $ State supplement $ Regional bonus $ 10,000 10,000 10,000 10,000 10,000 10, Total potential entitlement $ 26,500 7,000 7,000 10,000 10,000 10,000 10,000 10,000 10,000 Federal first home owner grant $ 7,000 7,000 7,000 10,000 10,000 10,000 10,000 10,000 10,000 Federal boost $ State bonus $ 13, Regional bonus $ 6, Total potential entitlement $ 7,000 7,000 7,000 10,000 10,000 10,000 10,000 10,000 10,000 Federal first home owner grant $ 7,000 7,000 7,000 10,000 10,000 10,000 10,000 10,000 10,000 Federal boost $ State bonus $ Regional bonus $ Total potential entitlement $ 17,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 Federal first home owner grant $ 7,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 Federal/state boost $ 10,000 - Regional bonus $ Total potential entitlement $ 7,000 15,000 15, Federal first home owner grant $ 7,000 15,000 15,000 Federal/state boost $ Regional bonus $ Total potential entitlement $ 7,000 7,000 7,000 10,000 10,000 10,000 10,000 10,000 10,000 Federal first home owner grant $ 7,000 7,000 7,000 10,000 10,000 10,000 10,000 10,000 10,000 Federal boost $ Total potential entitlement $ 7,000 7,000 7,000 3,000 3,000 3,000 3,000 3,000 3,000 Federal first home owner grant $ 7,000 7,000 7,000 3,000 3,000 3,000 3,000 3,000 3,000 Federal boost $ Source: NSW Office of State Revenue, State Revenue Office Victoria, Department of Finance (Government of Western Australia), QLD Treasury Since we last published on policy risks facing the Australian residential markets (see: Australian resi developers - Nearing the point of inflection), there have been a number of new developments on the policy front. We summarise these developments on the table in the following page, alongside those targeted towards foreign buyers (as discussed above). 1 July

57 Fig 103 Regulatory developments facing foreign investors in the last 6 months Date Body Measure Details Effects Dec-14 APRA Metrics identified for lenders that will trigger red flags Feb-15 FIRB Application fees for foreign investors The three things that APRA identified include: 1) focus on higher risk mortgage lending (eg. interest-only loans to owner occupiers, high LVR loans, very long term loans); 2) growth in lending to property investors; and 3) tougher loan affordability tests (the higher of a 2% buffer against the product rate or 7% to be used when assessing ability to repay) The fees are dependent on the value of the property. $5,000 for any property below $1m in value with an additional $10,000 for every $1m above $1m Limits lending capacity of the ADIs. See: (Listed property sector - Focussed on compliance) Added cost of foreign investment into Australia with many foreign investors placed in the sub $1m market. Feb-15 FIRB Foreign residential and agriculture property owners' register. Introduced as part of push to increase enforcement of foreign investment regulations. Increased enforcement of foreign investment rules - reduced motivation for illegally purchased properties. Apr-15 Federal government Temporary suspension of the Significant Investor Visa (SIV) The SIV is for foreign investors with $5m of investible capital to gain permanent residency. Eligible foreign investors must now invest: i) $500k in Australian venture capital or start-up businesses; ii) at least $1.5m in eligible managed funds or LICs that invest in emerging companies; and iii) a 'balancing investment' or up to $3m that do a combination of assets including residential property (10% limit on residential real estate). No direct effect on residential property. Highlights regulatory risk facing foreign capital into Australia. May-15 Federal government New fees and penalties for breachers of FIRB rules Fees and penalties include: 1) fines up to $100,000 for real estate agents who assist in illegal purchases; 2) penalties of up to 3 years jail and fines of $127,500 for individuals and $637,500 for companies; 3) removal of profits from sale of illegally purchased properties (plus 10% penalties); 4) third parties who knowingly assist will face fines of $42,500 (individuals) and $212,500 (companies). Increased enforcement of foreign investment rules - reduced motivation for illegally purchased properties. May-15 Federal government/ ATO Enforcement of foreign investor rules passed onto ATO This coincided with the introduction of harsher fines and fees for foreign investors. The ATO has greater enforcement capacity given its more heavily invested operational and financial detection capacities. Increased enforcement of foreign investment rules - reduced motivation for illegally purchased properties. May-15 Victorian State Government Taxes for foreign investment. Introduced alongside the Victorian State budget Two additional taxes for foreign citizens include: 1) 3% additional stamp duty for non-permanent residents; and 2) 0.5% land tax surcharge to absentee property owners who are not citizens or permanent residents. The tax was modified soon after to allow the Treasurer discretion to exempt foreign-controlled entities from the 3% stamp duty surcharge. Additional taxes on foreign investors, as well as majority foreign-controlled entities. The Treasurer exemption may grant relief for majority foreigncontrolled entities. Not yet effective. Source: APRA, Department of Immigration and Border Protection, FIRB, Department of Treasury and Finance, Macquarie Research, June 2015 Given the lack of compelling precedents in Australia, we look internationally for a reference point. We summarise the cooling measures since 2009 used in the Hong Kong and Singaporean markets in the table below. In the Hong Kong property market, government intervention is not new, with a 70% LTV limit introduced in However, given the movement in the market due to globally low interest rates and increasing mainland Chinese capital inflows, the HK government has had to intervene to stem price growth. Prices continued to rise despite these measures in Hong Kong. Both the HK and Singaporean markets showed similar results the introduction of cooling measures had a mild initial impact on volumes but price growth remained stubbornly high. 1 July

58 Fig 104 Summary of major Hong Kong and Singapore cooling measures Timeline Mortgage Non-owneroccupied residential/ Industrial and commercial properties Buyer stamp duty (BSD) Additional buyer s stamp duty (ABSD) Seller stamp duty (SSD) Public/ Subsidized housing Home Purchase Restriction Sep, 2009 Oct, 2009 Feb, 2010 Mar, 2010 Aug, 2010 Nov, 2010 Jan, 2011 Jun, 2011 Dec, 2011 Jul, 2012 Sep, 2012 Oct, 2012 Jan, 2013 Feb,2013 Jun, 2013 Aug, 2013 May, 2014 HK: 1st round of tightening by HKMA SG: Decrease in LTV limit HK: Threshold of mortgage rate at Hibor+0.7% or P - 3.1% HK: 2nd round of tightening by HKMA; SG: Lower LTV for individuals with 1 or more outstanding housing loans HK: 3rd round of tightening by HKMA SG: Lower LTV limit for individuals with 1 or more outstanding housing loans/ Implement LTV limit for nonindividuals HK: 4th round of tightening by HKMA HK: 5th round of tightening by HKMA SG: Limit max. loan tenor of all new home loans to 35 years; borrowers taking loans longer than 30 years with LTV of 60% (previously 80%) SG: LTVs for various scenarios are lowered by 10%. Minimum cash down payment increases from 10% to 25%. HK: 6th round of tightening by HKMA SG: Introduction of total debt service ratio: Total monthly debt obligations cannot exceed 60% of monthly gross income/ Refinement of rules regarding LTV limits: Guarantors as coborrowers. Income-weighted average age when applying rules of loan tenure SG: Maximum tenure for public housing loans reduced from 30yrs to 25yrs HK: Max LTV lowered to 60% HK: Max LTV lowered to 50% SG: 15%/10%/5% of SSD will be levied if the industrial property and land are resold within 1 st /2 nd /3 rd year. HK: Max LTV lowered to 40%. Car park space mortgage tenor limited to 15 years. HK: BSD for apartment value of HK$20m raised from 3.75% to 4.25% HK: BSD for apartment value of HK$2m raised from HK$100 to 1.5% of property value; Doubling BSD for apartment value above HK$2m, with the exception of first time home buyers HK: 1) allowing home buyers more time to sell their original units without paying double taxation, and 2) exempting DSD on the purchase of a onecar parking space acquired with a residential apartment SG: 1) 10% of ABSD for foreigners and non-individual buying any residential property; 2) 3% ABSD for permanent residents owning one and buying a second and subsequent residential property/ Singaporean Citizens owning two and buying the third and subsequent residential property HK: 15% of purchase price for all residential properties on top of existing stamp duty for all foreign buyers and local or foreign corporate purchasers SG: 1) BSD on multiple home purchases: 7% BSD levied at Singaporeans buying their second property and 7% for PRs buying their first property 2) Foreigners to pay 15% instead of 10% for their first property purchase SG: Introduced 1- year Seller's Stamp Duty (SSD) SG: Increased the holding period for imposition of SSD to 3 years from 1 year HK: Introduce 2-year Seller s Stamp Duty (SSD) SG: Increase in SSD and the holding period for imposition of SSD to 4 years HK: 20% of property value if properties are resold within 6 months; 15% if resold between six and 12 months; and raised from 10% if resold between 12 and 36 months SG: Removal Interest Absorption Scheme and Interest-Only Housing Loans (IOL) HK: Resumption for the development of subsidized housing HK: 5k eligible white-form applicants can buy subsidized flats in the secondary HOS market without the need to pay the land premium HK: To sell remaining 832 completed subsidized housing inventories in early 2013 SG: Mortgage Servicing Ratios (MSRs) for Purchase of New or Resale HDB Flats lowered from 40% to 35%; Housing Loans granted by MAS-Regulated FI will be up to 30% Source: HKMA, HKSAR government, Ministry of National Development (MND), URA, HDB, Macquarie Research, June 2015 HK: pilot program of HK Land for HK People in 2 residential sites 1 July

59 New Zealand New Zealand banks are heavily reliant on mortgages, similar to Australian banks, representing over half their assets. There have been a number of macro-prudential policies implemented in NZ to date: Late 2012: The RBNZ implemented LVR caps to buffer the financial system when house price growth reached 10% October 2013: Regulated lenders were required to cap 80%+ LVR mortgages to only 10% of their housing lending loans (prospective introduction). May 2015: Introduction of additional macro-prudential policy tools to be effective from 1 October Key changes were: i) investors in Auckland Council area are required to have a minimum of a 30% deposit; ii) an increase in the high LVR loans growth rate limit for lending outside of Auckland from 10% to 15%; and iii) retention of the 10% high LVR loan growth rate limit for owner-occupied purchases. The measures were introduced to directly target investor activity in Auckland. Investor loans increasing...will further action be taken? APRA released a report on 9 December 2014 providing its view on residential lending practices in Australia. APRA/ASIC is clearly concerned about the potential risk from a house price correction on the financial system. The APRA review was softer than expected. We had been expecting the implementation of a macro prudential tool targeted at investors to take some of the heat out of the resi market and whilst we thought the initial impact would likely only be temporary, APRA s announcement was softer than we thought. Indeed whilst the announcement mentions tools that APRA can apply, it is focussed on increasing the level of supervisory intensity in certain areas at this stage. APRA is focussed on two key areas: Investor lending growth materially above 10%. APRA has noted annual investor credit growth materially above a benchmark of 10% for the major lending institutions will be an important risk indicator that supervisors will take into account when reviewing the mortgage risk profile of ADI s. We note that investor housing credit growth was 10.4% in April 2015 (YoY) and up 9.7% on a twelve month rolling basis (refer chart above on the RHS), and we suspect APRA will place greater emphasis on this if growth moves further upwards. However we note that the proportion of sales to investors has increased for both MGR and SGP and are currently ~45% and 27% of resi sales respectively. Serviceability floor of 7%. APRA believes serviceability policies should incorporate a buffer of at least 2% above the loan product rate with a minimum floor assessment rate of 7%. The floor will have the impact of not increasing the availability of debt to the extent that mortgage rates were to reduce further. However clearly any reduction in mortgage rates will be to the benefit of disposable income. Interest-only review in conjunction with ASIC shows that the regulatory tone has changed. ASIC also announced that they will conduct surveillance into the provision of interest-only loans and will look at the conduct of lenders to ensure they are complying with consumer protection/responsible lending laws. Murray Review also flagged increased risk weights for mortgages for the banks. The Murray Review flagged increased capital for the banks sector in the form of increases in average mortgage risk weights for the major banks to 25-30% from 14-18%. 1 July

60 Outlook by major capital city market Sydney is expected to moderate steadily from here after outperforming other markets this cycle. While most of the fundamental drivers are still good migration and demand are still firm, relative to history rising supply and eroding affordability will constrain the degree of price growth achievable from here. Indeed, relatively weak affordability in Sydney compared to other markets will eventually drive interstate emigration as seen in previous cycles. As with other markets, higher rates will likely drive a modest price correction, with the timing and extent driven by the pace of interest rate tightening. Melbourne is likely to following a similar path in terms of price moderation as Sydney, even if that pace is a tad more subdued this cycle. Elevated and rising supply gains remain a source of concern, particularly in inner-city locations, although that is partly ameliorated by strong population gains of the year. Housing affordability levels are better placed than Sydney. Given these drivers, the key risk comes from a further aggressive run-up in supply, akin to the local experience of 2012, which will add to the risk of a larger pricing downturn. Brisbane continues to lag other markets this cycle, even as prices emerge back into recovery and should exhibit strong price growth into 2H15. There are clear macro reasons behind this slow recovery, due to weaker domestic growth and the slow pace of interstate migration out of both Sydney and Melbourne. Affordability levels in Brisbane are relatively good, given the recent price correction, which will offer a relatively larger buffer when mortgage rates eventually impact more significantly on affordability and pricing. Perth is slowing more tangibly after a firm run in 2013 and early The supercharger that was the mining investment cycle has turned markedly. In turn, this weighed heavily on state activity and more recently into household income and overseas migration. The pace of supply additions remains a source of concern, especially at a time when population and demand are pulling back more apparently, but appears to have slowed in the latest data point. Affordability is sound for now. 1 July

61 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06 Mar-09 Mar-12 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Macquarie Wealth Management Fig 105 Divergence continues between the states and by dwelling product Variable Indicator Chart Recent trends from indicator Implied outlook for market Housing affordability ratio Mortgage repayments as proportion of household incomes 70% 60% 50% 40% 30% 20% Sydney Melbourne Brisbane Perth Less affordable More affordable Housing affordability the combination of incomes, mortgage rates and housing prices has shown a divergence between the states. NSW and VIC have increased (less affordable), in line with dwelling price growth. Brisbane remains relatively affordable, by a clear margin Our economist expecting a further 25bp rate cut by 2015 which should be a positive for loan repayments (improving affordability). Furthermore, we note that if Sydney affordability was to reach previous highs (59% in 2004), this would imply a further 21% dwelling price growth. Mortgage rates Annual change in standard variable mortgage rates % VMR Change 40% Consequentive quarters of price falls (<0%) 30% Consequentive quarters of price gains (>10%) 20% 10% 0% -10% -20% -30% -40% -50% Jan-91 Jan-95 Jan-99 Jan-03 Jan-07 Jan-11 Jan-15 Changes in mortgage rates have been a consistent driver of Australian residential cycles over the past 30 years. Increases and decreases in rates to defined tipping points have traditionally been an important trigger for turning points in the housing cycle Strong housing price gains can run beyond the rate easing cycle (and well into the subsequent rate tightening cycle). The outlook for Australian housing will largely hinge on the timing (and extent) of the next action which our Economist currently forecasts at a short term easing stance and a longer term tightening stance. Demand Overseas and interstate migration '000 annual Mar-83 Mar-88 Mar-93 Mar-98 Mar-03 Mar-08 Mar-13 In terms of the demand drivers of the Australian housing market, most demographic factors are relatively slow-moving. The key exception relates to net migration. After a strong surge in net migration, there are now clearer signs of moderation in resourceintensive states of WA and QLD The pattern of net migration in Australia has clearly shifted. WA and QLD, previous beneficiaries of strong inflows, are now posting slower gains. Meanwhile, inflows into NSW and VIC have shown strong gains but the latest data point shows some moderation, driven by robust foreign immigration and diminished interstate migration NSW VIC QLD WA Demand Natural births and migration '000 annual A key demand driver for the overall housing market is population growth. Population growth has been elevated since the early 2000 s in Australia, largely driven by net migration statistics. That said, population growth is anticipated to moderate from here A decline in population growth would likely lead to less growth in demand for housing in Australia. Dwelling commencements are currently annualising at ~198k per annum, above prior peaks. We contend that current production will increasingly satisfy demand, allowing for fewer people per household and demolition estimates Births and Deaths Net Migration Supply Dwelling starts '000 annual Sep-91 Sep-94 Sep-97 Sep-00 Sep-03 Sep-06 Sep-09 Sep The outlook for dwelling commencements primarily reflects changes in mortgage rates and house prices. Recent upswing reflected current low rate settings and strong price gains. Approvals data signal further uplift near-term With approvals at 30 year highs, we expect that any further approval growth will need to be driven by the detached market given apartment price growth appears to be moderating. Foreign development may also distort this figure. Approvals Commencements Completions Source: Macquarie Research, ABS, RBA, APM, June July

62 Important disclosures: Recommendation definitions Macquarie - Australia/New Zealand Outperform return >3% in excess of benchmark return Neutral return within 3% of benchmark return Underperform return >3% below benchmark return Benchmark return is determined by long term nominal GDP growth plus 12 month forward market dividend yield Macquarie Asia/Europe Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return <-10% Macquarie First South - South Africa Outperform expected return >+10% Neutral expected return from -10% to +10% Underperform expected return <-10% Macquarie - Canada Outperform return >5% in excess of benchmark return Neutral return within 5% of benchmark return Underperform return >5% below benchmark return Macquarie - USA Outperform (Buy) return >5% in excess of Russell 3000 index return Neutral (Hold) return within 5% of Russell 3000 index return Underperform (Sell) return >5% below Russell 3000 index return Volatility index definition* This is calculated from the volatility of historical price movements. Very high highest risk Stock should be expected to move up or down % in a year investors should be aware this stock is highly speculative. High stock should be expected to move up or down at least 40 60% in a year investors should be aware this stock could be speculative. Medium stock should be expected to move up or down at least 30 40% in a year. Low medium stock should be expected to move up or down at least 25 30% in a year. Low stock should be expected to move up or down at least 15 25% in a year. * Applicable to Asia/Australian/NZ/Canada stocks only Recommendations 12 months Note: Quant recommendations may differ from Fundamental Analyst recommendations Financial definitions All "Adjusted" data items have had the following adjustments made: Added back: goodwill amortisation, provision for catastrophe reserves, IFRS derivatives & hedging, IFRS impairments & IFRS interest expense Excluded: non recurring items, asset revals, property revals, appraisal value uplift, preference dividends & minority interests EPS = adjusted net profit / efpowa* ROA = adjusted ebit / average total assets ROA Banks/Insurance = adjusted net profit /average total assets ROE = adjusted net profit / average shareholders funds Gross cashflow = adjusted net profit + depreciation *equivalent fully paid ordinary weighted average number of shares All Reported numbers for Australian/NZ listed stocks are modelled under IFRS (International Financial Reporting Standards). Recommendation proportions For quarter ending 31 March 2015 AU/NZ Asia RSA USA CA EUR Outperform 48.99% 59.51% 49.30% 43.79% 59.59% 52.20% (for US coverage by MCUSA, 7.42% of stocks followed are investment banking clients) Neutral 34.12% 26.62% 35.21% 50.29% 34.93% 31.32% (for US coverage by MCUSA, 5.68% of stocks followed are investment banking clients) Underperform 16.89% 13.87% 15.49% 5.93% 5.48% 16.48% (for US coverage by MCUSA, 0.87% of stocks followed are investment banking clients) MOC AU vs Small Ordinaries, & rec history (all figures in AUD currency unless noted) Note: Recommendation timeline if not a continuous line, then there was no Macquarie coverage at the time or there was an embargo period. Source: FactSet, Macquarie Research, June month target price methodology MOC AU: A$2.91 based on a DCF methodology Company-specific disclosures: AFG AU: MACQUARIE CAPITAL (AUSTRALIA) LIMITED or one of its affiliates managed or co-managed a public offering of securities of Australian Finance Group Ltd in the past 12 months, for which it received compensation. MACQUARIE EQUITIES LIMITED or one of its affiliates managed or comanaged a public offering of securities of Ltd in the past 24 months, for which it received compensation. Important disclosure information regarding the subject companies covered in this report is available at Target price risk disclosures: MOC AU: Any inability to compete successfully in their markets may harm the business. This could be a result of many factors which may include geographic mix and introduction of improved products or service offerings by competitors. The results of operations may be materially affected by global economic conditions generally, including conditions in financial markets. The company is exposed to market risks, such as changes in interest rates, foreign exchange rates and input prices. From time to time, the company will enter into transactions, including transactions in derivative instruments, to manage certain of these exposures. Analyst certification: The views expressed in this research reflect the personal views of the analyst(s) about the subject securities or issuers and no part of the compensation of the analyst(s) was, is, or will be directly or indirectly related to the inclusion of specific recommendations or views in this research. The analyst principally responsible for the preparation of this research receives compensation based on overall revenues of Macquarie Group Ltd (ABN , AFSL No ) ( MGL ) and its related entities (the Macquarie Group ) and has taken reasonable care to achieve and maintain independence and objectivity in making any recommendations. General disclosure: This research has been issued by Macquarie Securities (Australia) Limited (ABN , AFSL No ) a Participant of the Australian Securities Exchange (ASX) and Chi-X Australia Pty Limited. This research is distributed in Australia by Macquarie Equities Limited (ABN , AFSL No ) ("MEL"), a Participant of the ASX, and in New Zealand by Macquarie Equities New Zealand Limited ( MENZ ) an NZX Firm. Macquarie Private Wealth s services in New Zealand are provided by MENZ. Macquarie Bank Limited (ABN , AFSL No ) ( MBL ) is a company incorporated in Australia and authorised under the Banking Act 1959 (Australia) to conduct banking business in Australia. None of MBL, MGL or MENZ is registered as a bank in New Zealand by the Reserve Bank of New Zealand under the Reserve Bank of New Zealand Act Any MGL subsidiary noted in this research, apart from MBL, is not an authorised deposit-taking institution for the purposes of the Banking Act 1 July