The market was startled by Judo’s (ASX: JDO) trading update, with shares crashing 40%. While the bank points to most underlying metrics being on track or better, higher credit stress drives a 10% downgrade to fiscal 2026 pretax profit guidance. Fiscal 2027 guidance implies growth of 30%, but also disappointed.

Why it matters: The bank is taking specific provisions on three loans, which we estimate pushes its bad debts/loans to 90 basis points compared with our midcycle assumption of 50 basis points. Our fiscal 2026 and 2027 profit forecasts are lowered by 9% and 13%, respectively, due to higher bad debts.

  • Judo has raised specific provisions that may or may not result in Judo incurring actual losses, but the bigger question is whether they are pricing risk appropriately or simply taking on customers that other banks won’t finance. Given that provisions relate to a small number of exposures, it does not appear to be a systemic problem.
  • We don’t think loss rates will remain this high over the medium term, but they are being affected by economic conditions. We think fiscal 2027 will likely also be challenging, and our fiscal 2027 pretax profit forecast now sits 5% below the bottom of guidance.

The bottom line: Our fair value estimate for no-moat Judo is unchanged at AUD 1.60, with the time value of money offsetting the downside from lower short-term earnings. After the selloff, shares are now over 40% undervalued.

  • Given its rapid loan book growth and its status as a pure-play business lender leveraged to economic conditions, the risk of higher-than-expected losses is real. Hence, we think investors should be compensated for the risk. We use an 11% cost of equity in our valuation, compared with around 9% for the major banks.
  • The market has long shrugged off those risks, but this selloff has now swung the risk/reward pendulum the other way. Based on our fiscal 2027 forecasts, the bank trades at a P/E of just 8 times.

Business strategy & outlook

Judo Capital began as a nonbank lender in 2016, using seed capital and debt facilities to establish itself as a lender to Australian small and midsize businesses. It received a banking deposit license in 2019. Among its competitors are the big four Australian banks, which collectively have around 70% share of total business loans. Judo has less than 1% share of the total Australian business loan market, but we estimate roughly 2% of the SMB market.

Judo’s strategy is to pay attractive rates on term deposits, and more recently savings accounts, and charge an above-average return on its lending to generate a net interest margin above 3%. Judo justifies higher rates with its superior customer service offering, including a dedicated banker, fast approvals, and a less rigid approval process. Taking modestly greater risk and hence being compensated with higher rates is likely contributing to Judo’s growth.

We think Judo can continue to grow, but the exponential growth achieved in fiscal 2022 and 2023 will be difficult to replicate. Having access to cheap funding from the Reserve Bank of Australia during the pandemic allowed Judo to lend to more customers than it typically would target, at reasonably attractive margins and return on equity. As its funding costs rise by more than peers, Judo will now likely have to be more selective on which loans it funds. In fiscal 2022, Judo’s lending margin was 4.5% over the bank bill swap rate. By June 2023, it was down to 3.7% over BBSW. It has recovered to above 4%.

Profitability is also dependent on operating expenses being scaled and credit quality remaining within the industry average. While not tested through a cycle, Judo’s credit quality appears in line with the banking industry. Judo does not have legacy IT systems, branches, or a wide suite of products, but we still view it as a high-cost lender to the SMB sector. The banker/customer relationship is time-intensive. The success Judo currently enjoys could quickly cease from efforts to increase the number of consumers or the size of the loan book each banker is responsible for.

Bulls say

  • Judo’s strong customer focus attracts small and midsize business customers, enabling the bank to grow its loan book quickly and realize operating leverage benefits.
  • Starting from scratch and free of a parent company, Judo is unencumbered by legacy systems and processes that can interfere with prioritizing employee and customer satisfaction.
  • Margins expand as reduced competition for customer deposits results in the cost of Judo’s largest funding source, term deposits, falling.

Bears say

  • Judo’s point of differentiation is eroded by major banks adding more bankers to complement investments in digital offerings and use of data from payments and transaction accounts to make approval decisions.
  • A tougher regulatory capital burden relative to the majors makes it harder to compete on price and achieve a return on equity acceptable to shareholders.
  • Economic conditions could weaken materially and Judo’s loan book could experience much higher loss rates than peers.