Pepper Money Ltd

ASX:PPM

Earnings Call Transcript 2022-Q4

[Operator]

Good day, everyone, and welcome to the Pepper Money Limited CY 2022 Financial Results Conference Call. [Operator Instructions]At this time, I'd like to turn the floor over to Gordon Livingstone, Investor Relations at Pepper Money. Sir please go ahead.

[Gordon Livingstone, executive]

Good morning, everyone, and welcome to Pepper Money Limited's Calendar Year 2022 Financial Results Presentation. My name is Gordon Livingstone, Investor Relations at Pepper Money.I would like to begin by acknowledging the traditional custodians of the land on which we meet today, the Gadigal people of the Eora Nation. We pay our respects to each of their elders, past, present and emerging.Following the business update from Pepper Money's CEO, Mario Rehayem, Pepper's CFO, Therese McGrath, will walk us through the financials. After some closing remarks by Mario, there will be an opportunity to ask questions, which can be either via phone or submitted via the portal.I'll now pass over to Mario.

[Mario Rehayem, executive]

Thanks, Gordon.On behalf of my entire team at Pepper Money, I would like to thank, everyone, who has joined us today. Therese and I are proud to present Pepper Money's full-year results for calendar year 2022. Our performance yet again demonstrates the ongoing ability of Pepper Money to respond to any market conditions. We entered into 2022 with a strong focus on driving volume to support AUM growth. As we expected the macroeconomic condition and interest rate increases, we'd see the market slow down over the second half of the year.As we reported in the first half of 2022, we delivered above systems growth, growing originations by 53% on the first 6 months of 2021, and closing the first half of 2022 at AUD5.6 billion in total. It was this strategy to deliver a fast start in the first half that supported the business when markets softened materially in the second half of 2022. While both mortgages and asset finance originations in the second half slowed to AUD2.7 billion and AUD1.3 billion, respectively, we closed calendar year 2022 with a record originations of AUD9.6 billion, a growth of 14% on PCP. This meant for the full year, we outpaced the system, with mortgages in Australia growing 2x system and asset finance continuing at pace, growing 35x system over the same period.Our strategy to drive volume in the first half to secure our exit AUM saw us closed the year with lending AUM up 15% on PCP to AUD18.2 billion. Mortgages increased 10% versus PCP to AUD13.5 billion, and asset finance increased 35% versus 2021 to a record AUD4.7 billion. Pepper Money's strong track record in accessing debt capital markets and the strength of our longstanding funder and investor relationships developed over the past 2 decades really shows through when the market conditions are challenging, which was what was seen in 2022.We welcomed 4 new investors. We increased our warehouse capacity to AUD11.3 billion, up 14% on December 2021. We've successfully executed 7 public securitizations over the year, raising more than AUD5 billion in total. We also raised AUD1.8 billion through private term deals, and we have come out of the gate strong in 2023 with our first public securitization for the year settling tomorrow, PRS 35, a non-conforming deal of AUD billion, which we upsized from AUD500 million given the strength of demand.Before turning to profit and returns, I would just like to highlight the work we do in supporting our customers, our people and the communities in which we operate. Our people continue to be highly engaged. Again, in 2022, our employee engagement results placed us in the top 10% of companies globally, and this is not just a few employees. Our response rates are in excess of 90%.Our people called our trust and diversity of ideas as 2 of the key reasons they remain so highly engaged. We invest in our people through leadership development, annual pay parity reviews, engagement surveys and access to other development opportunities through our partnerships. Pepper Giving is an initiative run by employees through Pepper Money Giving Committee to provide support to key causes such as domestic violence and child education. And this is not just monetary support given. We have an active employee volunteering program where teams of employees commit their time and skills to help the causes we support, such as the Women's & Girl's Emergency Center at Burwood, and the Chris O'Brien Lifehouse at Camperdown.So in terms of profitability, while our volume growth was strong and we implemented front and back book price increases following Reserve Bank of Australia increases to the official cash rate, NIM continued to experience compression of the lag between BBSW increasing in advance of RBA rate rises and the delay associated to passing on the rates to customers, coupled with the impact of increased cost of funds as funding spreads widened. This meant that total operating income grew 9% to AUD408.2 million.As we consolidated the Stratton business from 1 July, 2022, factoring in 6 months of operating expenses, overall costs increased at a higher rate. Our pro-forma NPAT for the year closed at AUD142 million, was marginally ahead of the record profit we delivered in calendar year 2021. Statutory profit for 2022 grew 8% to AUD140.5 million. And for our shareholders, the Board has declared a final fully franked dividend of AUD0.051 per share, bringing total fully franked dividends in respect of 2022 to AUD0.105 per share, up from AUD0.09 per share in 2021, and delivering an annualized yield of 6.3%.As I'm sure you have heard me say, at Pepper Money, our mission is simple. It's to help people succeed. We focus on creating financial inclusion by challenging the way loans are designed and distributed. Our values provide the guide to how we do business and how we interact with our customers, stakeholders and each other and the core competences of the business, credit, funding, distribution and technology are all supported by over 22 years of data and through the cycle experience that allows the business to know when to drive volume, when to flex the margin and have a price for risk. It is the strength of our mission, values and core competencies that really come to the forefront when faced with headwinds of market conditions we endured in 2022. And we saw the business navigate the challenges to deliver such strong results.Before building into the operational business and financial performance, I think it's important to look at the market challenges experience, which we do believe will continue in the short term, at least. Australia, like most developed countries around the globe, saw interest rate rises with pace over 2022. From May to December, the RBA implemented 8 consecutive increases moving the OCR from 10 basis points to 310 basis points. February has seen a further rise of 25 basis points.As it takes around 3 months for a rate rise to start to have an impact on the customer discretionary income, this means it is only now that the flow on from the November and December rises start to be felt. Alongside the pressure, customers have come under from rising rate environment. The impact of inflation on household disposable income has also really started to be felt. Unsurprisingly, these factors have helped drive a significant deterioration in consumer confidence. The high and increasing interest rate environment, coupled with further rate rises unsurprisingly contribute to a marked reduction in mortgage volumes as seen through Equifax mortgage inquiry tracking, which has seen volumes drop circa 14% over the last 12 months and 21% in January 2023 versus January 2022 alone. And as published, property prices have also weakened, coming off 5% for the year to December.The final chart shows the pressure funding cost came under. The sharp and persistent increase in BBSW and swap rates drove the largest component on NIM compression. This was our operating environment for 2022. So how has this impacted our business? We entered 2022 prepared for rising rate environment and expected volatile debt markets alongside macroeconomic and geopolitical uncertainty and funding constraints. Against this backdrop, we accelerated the opportunities to grow our loan books and delivered record originations of AUD5.6 billion in the first half, up 53% on first half 2021.As interest rates started to rise and funding cost volatility emerged, we took a view to slow down new applications. In 2022, Q3 versus Q2 mortgage applications declined 39%. And while Q4 on Q3 declined to further 24%, the rate of decline has started to taper. And for the full year, applications for mortgages were down 16% on calendar year 2021. Asset finance market corrected more quickly. Q3 versus Q2 applications declined 13%, but returned to growth in Q4, growing 10% on Q3. And the full-year applications for asset finance closed 35% up on prior year.The softening in application translates to originations, with second half 2022 down 29% on the first half. The key, though, is closing AUM, as this provides the base income flow for the next year. And the strategy of driving volume growth in the first half allowed us to grow AUM to a record AUD18.2 billion for our lending portfolio, a growth of 15% on December 2021. Following on from this, it's not surprising while year-on-year, we outpaced the market in mortgages growing 2x system. It was a tale of 2 halves, with the first half 2022 growing 4x and the second half 2022 slipping back, and we were 2.5x below systems growth.As noted, total system declined in the second half. Our diversification into asset finance at the end of Q4 2014 and how we have built, extended and grown products, channels, technology platforms and partnerships really shows through when we look at how the business outstripped the market by 35x for the full year, 21.5x in the first half and 9.8x in the second half. I know that 2 half numbers don't add up to 35%. It's because total market declined in both halves, so we set the base to 0. Arguably, this means we grew even faster than our reported 35x.Now to focus on our pricing response to the rate changes on how we flex to our non-conforming product range in the second half. This slide illustrates how we responded in terms of price changes. As our funding costs increased, we have moved both front and back book pricing in mortgages and front book pricing and asset finance, given it is a fixed rate product. In mortgages, since the RBI started to increase interest rates in May this year until the end of December, we moved our back book pricing by 36 basis points over OCR. And since the beginning of the year, we moved the front book by a blend of 16 basis points over the OCR. As a result, specifically over half 2 over half 1 2022, average portfolio rate increased by 2.09%. This increase, however, was partially offset by ongoing increase in BBSW, as well as widening margins on new issuances, which drove up the cost of funds.Our asset finance business has seen significant pressure on funding margins as swap rates have widened over the reporting period. This has necessitated a series of front book rate increases to maintain business performance. And on average, we moved commercial 53 basis points over [ 3 ] years swap and novated by 23 basis points. Given our strategies half-on-half, it's probably more interesting to look at the half-on-half performance in mortgages.So turning to the next page. As mentioned earlier, we delivered record originations for mortgages in 2022 at AUD6.8 billion, a growth of 7% on PCP. Our focus on volume in the first half is evident through Prime, contributing 55% of originations. We grew total originations by 48% on the first half of 2021. Our diverse product range gives us options to shift the mix of our originations to better manage margin versus volume. As the May, June and July rate rises took effect and given the pressure on the cost of funds, we shifted our originations focus, which I implied at the half year results we would do to drive volume from our higher-yielding non-conforming products. This saw the mix of originations in the second half shift to non-conforming, which delivered 53% of originations, 47% Near Prime and 6% Specialist. We are a business that knows how to price for risk and one way of controlling risk in the portfolio is managing LVRs. In the first half, our portfolio had a dynamic LVR of 54% and the second half, 58%, which reflects the softening in property prices.We also take a conservative approach to the type of security we accept, with single-dwelling freestanding homes representing 78% of our portfolio. Pepper Money remains committed to helping those customers underserved by the traditional banks by creating financial inclusion, with 31% of originations in 2022 coming from self-employed and small businesses. For 6 consecutive years, with year-on-year volume growth, we retained and improved our industry-leading turnaround times. We make the complex simple through our in-house purpose-built technology and the depth of our data analytics. We continue to deliver fully underwritten non-conditional approvals in under 7 hours.Now on to asset finance. Our asset finance business continues to grow and expand its products, distribution and customer footprint. The business continued over 2022 to surpass the origination records set in 2021. Total originations at AUD2.8 billion grew 35% on PCP, bringing total AUM to a record AUD4.7 billion, up 35% on PCP. And the business now contributes 37% of total operating income. Our acquisition of one of the largest online asset finance brokers in Australia, Stratton Finance, completed on the 1st of July 2022, and we have been working on extending revenue synergies for our asset finance and mortgage businesses through leveraging on Stratton's extensive customer base and their in-house broker and franchise distribution footprint.Continuing on with asset finance. Our focus on volume in the first half is evident through Tier A 100% clean credit, contributing 61% of the originations. First half asset finance grew origination 67% on first half 2021. The mix shifted in the second half with Tier B and C contributing 44% of originations. One key advantage of our asset finance business has been the ability to extend and grow across multiple fronts through new products and markets in novated leasing, AB and commercial, or through the ability to grow share of wallet with the focus of ease of doing business and a customer-centric approach, which is delivered through our purpose-built platform, Solana, with multiple API integrations and the use of biometrics e-signing and real-time payments to ensure we deliver on our speed to yes and our speed to cash.Moving to funding. We have a strong and long established track record in debt capital markets. We have a broad and deep investor base of both domestic and global debt investors supporting us over the past 2 decades. Since 2003 to the end of 2022, we have raised in excess of AUD33.2 billion across 54 transactions via our 4 programs, 3 RMBS, namely Pepper Prime, PRS, Pepper Social and on ABS program called SPARKZ. It is the strength and the longevity of our relationship that with investors and our loan performance track record that allows the business to continue to raise funds and grow even given the challenging market conditions.We increased our warehouse capacity to AUD11.3 billion, up 14% on December 2021, giving us significant scope to fund our aspirations for growth across both mortgages and asset finance. We have raised from the public markets in excess of AUD5 billion in calendar year 2022. This was a record for our business. We completed 7 public securitizations in total. And since our half year results, we completed PRS 33 of AUD500 million; Pepper Prime 2022-2 of AUD1.25 billion and PRS 34 of AUD750 million. And as I mentioned earlier, we have had a strong entry into 2023, where tomorrow, we will settle our first securitization for the year, PRS 35, which is mainly composed of non-conforming loans. This is a deal which we upsized from AUD500 million to AUD1 billion. As I've said in the past, we have always taken a prudent approach to funding and maintained a minimum of 6 months of headroom. This is a part of our ongoing strategy that allows us to be prepared to manage any cycle, whether it's up or down.On to operations, our efficient and scalable shared technology platform and digital capabilities is a key factor enabling the business to manage and fulfill record originations. With both Sage and Solana now accepting 100% of all applications, we were able to create significant efficiencies, decision consistency and market-leading turnaround times for our introducers, brokers and customers.Solana also delivered record levels of auto approval, reaching 47%, playing a material role in achieving a customer NPS score of 62.5%. Our servicing platform, Apollo, continued to deliver enhanced customer self-help options and materially reduced customer asset post-settlement. We continue to leverage our technology stack, creating capacity and efficiencies to accommodate future growth. We are listening to our customers and partners, designing solutions to give them more ways to engage and interact with us.And before handing over to Therese, I would like to touch on our continuing focus on sustainability. Pepper Money has been built on discovering new ways to finance ambition with the mission to help people succeed. Pepper Money has built strong foundations of supporting the community, embedding good corporate governance and lending responsibly to our customers. And we are on the path to continue to strengthen our ESG framework to provide a quantifiable guide for our employees and stakeholders on the standards we are committed to.And while we had many initiatives over 2022, whether it's the investment we make in our people through the wellness programs, annual pay parity reviews, leadership development, which supported our engagement scores through to our Pepper Giving program run by employees across the company; to determine whether -- where we should invest, not just dollars but time and assets through our employee volunteer program. The one I would like to call out was our Pepper Shoutout initiative. All over Australia, [indiscernible] small and large are helping others succeed in tough times.Pepper Money wanted to recognize these people in a way that is designed to connect our communities. As a result, Pepper Money created the Shoutout campaign to help further the efforts of people making a real-life difference to others across Australia. Over 300 nominations were received and in total, 58 awards were provided in 2022 for people nominated by others in their community. Each award that Pepper Money game was thoughtfully designed to meet the needs of the person and their situation by identifying opportunities to extend the work being done and recognize the person by doing something special that is uniquely suited to them.I will now turn over to Therese to run through the financials before I close out on outlook and then take a Q&A.

[Therese McGrath, executive]

Thank you, Mario, and good morning, everyone.As Mario has largely covered off most items on this page, I will just touch on a few points before moving to net interest margin, NIM, and our credit performance. And while today, I'll be focusing on our pro forma results, our statutory net profit at AUD140.5 million grew 8% on PCP. As noted by Mario, originations at AUD9.6 billion grew 14% on PCP, with lending AUM closing 2022 at AUD18.2 billion, an increase of 15% on the prior comparable period. Total AUM closed at AUD19.2 billion, a growth of 13% on 2021. Strong closing AUM is always a focus of the business, given AUM is a key driver of future period income.Volume growth was partially offset by further compression in net interest margin, which at 2.2% was 36 basis points down versus PCP. I will address the movement in NIM in detail in the next slide. And while we delivered record volume growth, total operating income of AUD408 million did not keep pace with the origination growth given NIM compression. Mortgage operating income of AUD247 million was marginally down 4% on PCP, with volume gains offset by NIM compression, coupled with an increase to credit expense.Asset finance operating income grew 35% on PCP to AUD149.6 million, as the business continues to drive scale and gain share. The positive credit performance of the portfolio continued and credit expenses reduced in part through the release of model overlays. Asset finance contributed 37% of the total operating income in 2022, up from 29% in 2021 and 24% in 2020.Loan and other servicing operating income at AUD11 million grew 25% on PCP, and this was mainly driven by the broker servicing business, which we commenced in quarter 4 2020. Total operating expenses of AUD205 million includes both the consolidation of Stratton Finance for the 6 months to 31st December, as well as a one-off charge of AUD2.1 million booked in the first half of the year relating to the impairment of an equity investment we held in Volt Bank. So excluding this impairment and adjusting for Stratton, our expenses grew 7% year-on-year, which was largely due to the increase in FTE for our broker servicing business, the cost of which we recover, plus a margin through operating income.As noted, loan and other servicing income grew 25% on PCP. After normalizing reported CTI of 46% for the impairment in Volt and the consolidation of Stratton, underlying CTI at 44% was only 1% higher than 2021. The 22 years of experience we have of managing through all cycles shows through our profit. We know our drivers, and we know how to leverage them. In an intensely competitive mortgage market with margins compressing, we know when to grow volumes and went to rebalance to the higher-yielding products. Our business mix provides a balanced portfolio with the right blend of short- and long-term lending assets. We have a disciplined approach to costs, and our ongoing investment in our tech stack enables scale to leverage our cost base. This saw the business deliver pro forma EBITDA of AUD237 million, up 3% on PCP and pro forma NPAT of AUD142 million, which is in line with our record profit delivered in 2021.Now turning to NIM. The impact of increasing BBSW as swap rates ahead of our ability to move price is clearly seen in these NIM waterfalls. Over the first half of 2022, average NIM of 2.29% declined 23 basis points on the prior half. The positive flow-through from strong capital markets in 2021 supported the favorable variance in external funding, but this was offset by reduced customer rates driven by price competition and the fact that the May-June RBA rate changes and our responding price increases had only partially flown through at June. But the largest contributor to NIM compression over the first half was BBSW swap volatility, which deteriorated 24 basis points on the prior half.As we all know, the second half of 2022 was more volatile given the consecutive rate rises by the RBA, coupled with ongoing swap rate deterioration. The waterfall show how we, as a business, responded to the RBA rate increases through both back and front book price increases. Mario covered off our pricing responses earlier. Our average NIM for the second half at 2.11% benefited 173 basis points from customer rate increases when compared to half 1.However, the continued BBSW swap rate volatility, coupled with weakening capital markets saw NIM decrease by 191 basis points half-on-half, completely eroding the benefit of customer rate changes. As such, our second half NIM was 2.11%, and was 18 basis points down on the first half. I do need to point out that the December exit NIM of 2.29% is higher than the second half average, as well as being slightly ahead of the June exit NIM of 2.17%. This reflects some stability returning to capital markets as well as price increases flowing through.Focusing on mortgages, which is the graph on the bottom left. The NIM compression we reported over 2021 continue to flow through into this year, and has been accelerated by the BBSW increases. At 1.9% on average for the second half of 2022, the reduction of mortgage NIM has been impacted by the positive mix shift to higher-yielding non-conforming products plus price increases, but these were offset by the volatility in BBSW and further deterioration in external margins. Again, it is worth noting that mortgages December exit NIM of 2.03% is higher than the second half average of 1.9% as we've started to see BBSW stabilize and our price increases flow through the book.Now to asset finance, which is the graph on the lower right-hand side. The volatility in swap rates is clearly seen in our asset finance NIM. Over the second half of 2022, NIM contracted 71 basis points from rising swap rates. This was on top of a contraction of 27 basis points in the first half of 2022. And while we moved customer rates up by 50 basis points in the second half, this was eroded by adverse cost of funds as well as business mix.The novated lease segment grew as a percent of total, moving from 7% of originations in the first half to 13% in the second half. While novated lease has a low NIM as its salary sacrificed, it virtually has no credit losses, so margin after losses is maintained. As our asset finance business is fixed rate, we hedge the book almost every 2 days, which does allow for some protection in terms of swap rates. What we did see, however, were rates moving faster than even our hedging program. These factors contributed to asset finance NIM reducing from 3.07% first half 2022 to 2.75% in the second half. Again, asset finance December exit NIM at 3.02% is showing a return to the average rate as swap rates stabilize.Now to focus on the credit quality of our portfolio. We have high-quality residential and asset lending businesses with more than [ 22 years ] experience in credit and underwriting through all cycles. We know how to manage distressed assets and know how to analyze what causes the distress and take the learnings into our credit policies. And on top of this, we are prudent in our approach to provisioning.Total credit expense increased by AUD9 million on PCP or 35%. As we move through 2022 and as the RBA rate rises continue, we chose to increase the weight of the downside case in respect of macroeconomic variables that drive credit modeling. We consider this prudent given the likelihood that the 8 consecutive interest rate rises the RBA implemented over 2022 would likely have a significant impact on consumer disposable income. At the end of December, we hold total provisions of AUD122.2 million, a coverage ratio at 0.67% of AUM, up from 0.62% as at June 2022. Including post-model overlays, total credit expense increased 35% on the prior comparable period to AUD33 million.2022 included a reduction of AUD12 million in overlays in asset finance, given the underlying performance of the portfolio and the clean credit mix. We continue to monitor early indicators of potential future loss through the 90-plus days arrears as per the chart on the bottom right-hand side. Please note that as per industry standard, COVID hardships in 2020 and early 2021 have been removed. While 90-plus-day arrears trended up towards year-end, mortgages at 0.99% of AUM in December is well below the longer-term average of 1.2%. And asset finance at 0.26% is returning to pre-COVID levels. However, as noted, we are prudent, hence, continue to hold AUD20 million in post-model overlays.Turning to expense management. The underlying picture is slightly muddied due to the consolidation of Stratton in the second half of the year. While our reported pro forma operating expenses of AUD205 million increased 18% on PCP, if we remove the impact of Stratton and the one-time impairment to our investment in Volt Bank, expenses grew more modest 7%.Reported expense growth was largely due to an increase in FTE, with our online and broker servicing businesses growing by 205 people December-on-December. Broker servicing FTE costs are fully recovered, plus a margin via operating income, which I noted earlier, increased 25% year-on-year. Our core FTE base continued to show efficiency gains, with FTE down 2% year-on-year. As we balance activities for lending between Australia and Manila, we continue to manage the increase to the average cost per FTE at 3%, which correlates to our internal in-salary and wage inflation.Marketing spend increased AUD2 million on PCP, reflecting the impact of Stratton. However, the underlying reinvestment rate of 3% of total operating income remains constant year-on-year. Technology costs increased in line with FTE. It's now largely [ cost and risk fees ]. Notably, depreciation declined, reflecting our consistent year-on-year investment in our platforms, as well as the impact of moving to cloud and software-as-a-service where costs are OpExed. Amortization increased by $0.5 million for Stratton intangibles.One area to note, in terms of the impact on total expenses and CTI is corporate interest, which increased by $9 million year-on-year. This is the impact of BBSY volatility on our corporate debt facilities as we drew down on the CDS for the Stratton acquisition and subordinated debt for funding.Now turning to the core metrics. Our value trade continues to be volume and margin, supported by portfolio mix, coupled with disciplined cost management and leveraging productivity through a constant reinvestment ratio in marketing and technology drives performance. For the full year, volume growth is reflected through our record originations across both mortgages and asset finance, supporting an uplift in lending AUM of 15% on PCP and total AUM of 13% on December 2021 close.Total operating income grew 9% on PCP, while volume supported the business in the first half of the year, challenging market conditions and the pressure on NIM did see operating income yield fall marginally year-on-year to 2.3%. Reported CTI 46% was impacted by the consolidation of Stratton and the impairment previously noted. Removing these items, CTI was 44%, a slight deterioration on 2021. But if we were also to adjust for the impact of BBSY volatility on our corporate interest, CTI would be just below 43%, in line with 2021.The depth of our data capabilities, credit underwriting and our risk-based basic approach has seen continued improvement in the quality of our assets with loan losses as a percent of AUM improving to 0.22% excluding management overlay. Given the strong performance in capital management of the business, the Board has declared a final fully-franked dividend of $0.051 per share, which is an annualized dividend yield of 6.3%.So turning now to Slide 21. As I've largely covered off most items in the income statement, I will now just go to Page 22 and our balance sheet. The main movement in the balance sheet has been to goodwill and intangibles, reflecting the acquisition of Stratton Finance. Loans and advances as at 31 December, 2022 of $18.3 billion reflect the 15% net portfolio growth on December 2021. We originated $9.6 billion in new financial assets over the period. The net asset growth was financed by the issuance of public term securitizations of just over $5 billion, a 14% uplift in the warehouse capacity on 2021 year-end and a further $1.8 billion in private term securitization.Net assets at 31 December, 2022 grew 15% over PCP, in line with business origination growth. Cash and cash equivalents at the year-end stood at $1.2 billion and retained earnings reflects sustained profit delivered by the business over 2022, net of dividend paid in the year. And as usual, we continue to manage capital, balancing between holding sufficient levels to manage in uncertain markets and knowing when and where to invest for growth.Thank you. And I will now hand back to Mario to close.

[Mario Rehayem, executive]

Thanks, Therese. Before I open for questions and as we look forward, I would like to note the following: our strategy to drive volume in the first half helped us deliver record originations in 2022. We continued our double-digit AUM growth, which supports future income. Our credit and underwriting and portfolio mix delivered strong loan book performance. We have a path to deliver more new products over 2023 adding to our diversified product range.Our funding record speaks for itself, and we are well positioned to capitalize on growth across all our segments. But I acknowledge that particularly in the short term, there are challenges in terms of inflationary pressures, continuing rate rises and lower credit growth, but this is not foreign territory for us, and we know how to navigate through the challenges.In the medium term, there are indicators that suggest we will see green shoots emerge towards the end of 2023 and into 2024. So before heading into Q&A, why does Pepper Money succeed? We are a leading nonbank with a proven track record of managing through the cycle with a demonstrated track record for growth, significant warehouse capacity that is set up for funding through the cycle and well positioned for growth when markets permit. Our digitally-enabled tools developed to place confidence in the hands of our brokers and customers by making complex simple.Our deep credit knowledge position us at the forefront of knowing who and where to lend and how to price for that risk. The diversified products we offer gives an offensive and defensive strategy that is reflective of the market opportunity. With over 22 years of historical loan performance data proving invaluable for disciplined growth in complex borrower situations.And finally, we have a strong and experienced management team with a proven track record of success. Thank you for your time. Now we will hand it back to the operator to open the lines for questions.

[Operator]

[Operator Instructions] And our first question today comes from [ John Lee ] from Goldman Sachs.

[Unknown Analyst]

Firstly, just wondering what the economics of prime lending kind of look like as rates continue to normalize higher? And can that book continue to grow as the prime book amortizes?

[Therese McGrath, executive]

Would you mind repeating that? We found it a little bit difficult to hear.

[Unknown Analyst]

Hello. Can you hear me? Now is it clear?

[Therese McGrath, executive]

Yes.

[Unknown Analyst]

Yes. So just wondering what the economics of prime lending looks like as rates normalize higher? And can that book continue to grow as the prime book amortizes? And then I've got more question after that.

[Mario Rehayem, executive]

Thanks for your question, John. Where prime is today, we have taken a very conservative view in the context of an overall portfolio mix is how we operate the mortgage business. We have seen a softening in prime, and that is mostly led by us because of the sheer competitiveness that the banks are playing out there with cashback offers and the like. So for the interim and where cost of funds are today, we will take a softer approach towards prime, which is why our diversity of products comes into play. So we've leaned into our near prime and nonperforming into our commercial lending and into our asset finance business, which gives us that balanced approach to still stay relevant in the prime area, but doesn't have to be overweight in prime.

[Unknown Analyst]

Yes. That's very clear. And then just another question. So servicing and other income in this half was quite a large jump in -- compared to the first half. So I was wondering how sustainable that is going into FY '23?

[Therese McGrath, executive]

Yes. Actually, that just reflects our broker servicing business that we started in quarter 4 2020, actually annualizing its way through. So as that grows, then we'll actually start to see the revenue grow as well. So the delta that you're seeing from $8.8 million to $11 million year-on-year or 25% is down to the broker servicing business we started in Q4 2020.

[Operator]

Our next question comes from Tom Strong from Citi.

[Thomas Strong, analyst]

Just following on from the previous question, if I look at the competition in prime mortgages, if anything, it's probably accelerated in January, we've sort of seen quite sharp pricing from the majors and some increased cashbacks as well. So do you expect the mortgage AUM to decline further in the first half before the sort of green shoots come through later in the year as rates potentially stabilize?

[Mario Rehayem, executive]

We have definitely seen attrition stabilize in the back half of last year and early 2023. With regards to prime lending, it really does reflect where the banks are planning at the moment. We do feel that the banks are going to be in a position to start raising more deposits, which will mean that the cost of funds will start to increase, which will give us an opportunity to call back some of that market share on that.

[Thomas Strong, analyst]

All right. Perfect. Now that makes sense. And just in terms of your comments, I guess, around broadening the product suite in mortgages, clearly, as primes come off, given how difficult competition is, you're sort of seeing increased origination in near prime and specialists. Just in terms of, I guess, the competitive landscape there as well. A lot of your nonbank peers are facing the same competitive headwinds in the price and are trying to go into higher-margin products. Does that sort of explain why the front book yield in nonconforming was sort of flat from October to December? It looks like one of the only products where the front book pricing was relatively stable in the December quarter. Is that I guess, a competitive headwind that's sort of keeping that flat.

[Mario Rehayem, executive]

I'll just touch on a couple of points. So we have always been diversified within near prime and specialists or nonconforming mortgages. And we've always took advantage of the lower cost of funds in the last couple of years to really ramp up prime because it was really strong NIM generating for very low risk. So -- but our core business has always been nonconforming mortgages.With regards to your observations on the front book pricing, there is a couple of elements that factor into that. First and foremost, the entry of our new product, a Near Prime Clear. So Near Prime Clear is a product that has been positioned in between our prime product and our near prime product. And that has taken off really well. But that is a lower yielding product, but is definitely influencing our nonconforming volume but also has a better credit profile than your typical near prime product, which means there is less risk and less probability for arrears and losses on that. So that's where you're seeing that.The second piece to that is correct in what you're saying. There is competition, but there isn't really much competition of new players. This is predominantly an area that is serviced by traditional nonconforming lenders. And the reasons for that, it is complex lending, and you have to really understand how to price for risk. So barriers of entry in this particular area is very high. There are many that have tried and have pulled out fairly quickly, purely because of not understanding how to price for risk.

[Operator]

Our next question comes from Jeff Cai from Jarden.

[Jeff Cai, analyst]

Look, just a question on the mortgage runoff, which is accelerated in the half. And how should we think about that going forward? Like is the worst over as those you can refinance have done so? Or do you see it getting worse if the major banks remain ever competitive and you've also repriced your back book?

[Mario Rehayem, executive]

As I said earlier, I think our observation is as banks need to start to raise deposits and the price between our front book pricing and the bank front book pricing starts to tighten, we will see a material softening in what we believe is in the prime attrition rates. Remember that at the point of when we started to raise rates, the banks had the luxury of the TFS funding and the likes, which allow them then to have a massive arbitrage between our front book pricing because you're talking in excess of 100 basis points on our front book pricing. So what we are seeing now is that 100 basis points tightening and we are going back to -- and we believe are going back to long-term averages of banks being priced around 60 basis points wider than our particular prime product. So we should see a stabilization coming through over the next 6 to 12 months.

[Jeff Cai, analyst]

Great. And then a second question on credit quality. Can you talk about what you're seeing in terms of mortgage arrears in January and February so far, particularly talking to your non-prime mortgage book?

[Mario Rehayem, executive]

Sure. Well, with regards to loan performance, we are tracking well inside our long-term average. I just want to take this opportunity to note that we are -- have a very strong position on our weighted average LVR position, which is sitting at around 58%. We obviously expect to see some kind of arrears to pick up because there isn't a book -- a loan book in town that you placed 300-plus basis points on that is not going to impact some form of repayment trajectory. But in saying that, the way that we are looking at it is, first and foremost, the credit quality coming in the door. So our selective process bringing customers on board with ample buffers and the likes, play a material part.Our focus mid-last year to really hone in on lower LVR lending contributed significantly not only to our volume, but also to our weighted average LVR position. Now why that's important because arrears doesn't always translate to losses. Now you may get a transitional period and history has shown that you get a transitional period with arrears and that is when customers are readjusting their discretionary spend to find their feet again and then they find a natural rhythm post that. That usually takes 3 to 4 months to find that new rhythm. And then post that, then people are back on track in pain.So we're very comfortable with what we have seen so far. And also, we don't have a mortgage cliff. So remember that Pepper book is 100% variable, and we are fast to act in regards to passing on those rate rises. So many of the banks do look at our actual portfolio performance as a precursor or a market intel because we are very quick to act and it's a 100% variable book. So we're not expecting to see anything outside or any surprises because we are monitoring that on a daily basis.

[Operator]

Our next question comes from Josh Freiman from Macquarie.

[Joshua Freiman, analyst]

Just a couple of questions from me. If I sort of take my first question and expand on, I think it was one of the prior questions on the call. Just on returns on prime mortgages. If I perhaps phrase it a different way, are you guys actually meeting your cost of capital hurdles on the prime book? And does it actually make sense in this environment for you guys to originate more of those loans?

[Mario Rehayem, executive]

It's a good question. I can comfortably and confidently tell you that we always meet our return hurdles internally. Hence, the reason why we take a very disciplined approach. We never write volume for the sake of writing volume. You can see when the market got really competitive and there was volatility in the cost of funds and the spreads were widening in our funding. We took a very disciplined approach to slow down originations. So that is above and beyond the market actually contracting. We took a conservative effort. And you can see very quickly on the page, which shows the front book and back book pricing. I think it's on Page 8. You can see very quickly how the rates are increased, and we are not shy of pricing ourselves to where to meet our minimum return hurdles.If you remember back when we did the prospectus, we spoke about the business always looking to generate a floor of a minimum of 200 basis points of NIM. That is still evident today even through all the headwinds and challenges that we have had. And we are running the portfolio on a very conservative balanced approach, but prime on its own accord always has to stand up on its own feet.

[Joshua Freiman, analyst]

Okay. And just moving on to my second question. I noticed that you mentioned that some of the major banks have those refinancing clips of fixed rates. You guys are expecting your attrition and perhaps growth in prime to pick up over the next 12 months. Just looking then at your slide, I think it's Slide 8, where you have prime yield on front book rates at 6.29% in December. And there's been another rate rise since then. But we see major banks and digital loan offerings at about 5% here. Why do you think that there would be some proposition that would move major bank prime customers into your book in this sort of environment?

[Mario Rehayem, executive]

Yes. We have always priced wider than the banks, and that is something that we have always had a value proposition outside of rate. So people come to pepper for purpose, not for price. And that has always been part of our value proposition in the niches that we offer in our credit ability. So for us, this is not foreign territory. We have always priced in between 50 basis points to 80 basis points wider than the banks. In this particular market, we are priced even further than that, and that is because, obviously, the return hurdle that we have was not being met. So we definitely increased our rates. We do feel that the banks will need to raise rates purely because their cost of funds will increase over time. And we are very comfortable with that, that gap will start to become more tighter or the gap will be bridged, which will give us then more ability to originate prime loans over time.

[Operator]

Our next question comes from Tom Camilleri from Wilsons.

[Tom Camilleri, analyst]

It was an impressive result in asset finance at 35x system growth. Can you just give us some further color on what you're doing differently here? And if it's largely price driven. And can you also talk to us about the competitive dynamics you're seeing in the industry and who you're taking share from there?

[Mario Rehayem, executive]

Sure. I think first and foremost, it's definitely not price. We are never a price taker regardless of the asset class, whether it's mortgages or asset finance. The value proposition within asset finance really does honing on very similar traits to our mortgage business, which is, first and foremost, our technology. We have a very sophisticated set of API integrations into the largest originators of asset finance or car loans. And that be a very extensive distribution footprint that gives us a very diverse ability to originate loans.The other piece that we have is our credit profile of the type of loans that we take on. Very similar to the credit cascading model we have in mortgages, we have that in asset finance as well. So what that really means is that the probability to yes, when you deal with Pepper, whether it's mortgages or asset, is much higher than those that you do with in the other lenders.The other piece that we have is our ability to continue to grow market share with our existing distributors of product or introduces, but also increasing our distribution footprint. We have onboarded a number of very large brands in the market that are very well-known, some are global brands that have chosen Pepper as their financier of choice, and that is through asset finance.The other thing that we've done with asset finance is recently released our real-time payments. So we've always had market-leading time to yes. Now we are about to launch or we have launched the market-leading time to cash. So what that really does mean is that we have been able to meet the customer demand of wanting to pick up that vehicle or asset at that time of purchase. And we are able to do that as fast as the bank transfer can go through.We also, a couple of years ago, mentioned that we were going to expand into novated leasing. This has again proven avoiding the market that we've been able to capitalize on, and we have seen significant growth, partnering up with some of the largest and best operators in the novated leasing space. We have gone from 0 to roughly around 13% of our flow being novated leasing. Now novated leasing is a product that is well known in Australia. Its performance speaks for itself. It's very, very -- performs exceptionally well. It has a slightly lower yield, but you expect that when you're taking less risk in the book.

[Tom Camilleri, analyst]

That's very comprehensive. And now just pivoting a little bit just back to loan losses. We're seeing this start to normalize a little bit of historical lows. But could you just please give us some color on how losses on 90 days arrears looks within the free mortgage book category? In other words, yes, where does near prime specialist lending areas versus the prime category.

[Mario Rehayem, executive]

The 90-day arrears today sit below 1%, and we are comfortable where they are. As I said, I mentioned earlier, we are tracking across all of our asset classes and products well below our long-term average. And again, I want to reiterate the strength of the weighted average LVR, which is at 58%, but also our choice of collateral that we choose to originate. So we are very particular in the type of collateral, i.e., we don't do high density. We don't do rural lifestyle. We are a traditional lender for your traditional Red Brick Australia. And the reasons for that is that collateral is much more resilient than those that are high density and the likes. And also for us, it's an area that we've played in for 23 years. So we're very confident in the level of risk that we take on in those particular areas.

[Tom Camilleri, analyst]

And then just a final housekeeping one. Stratton, can we get some further color on the performance to date and now you're happy with how the business is tracking?

[Mario Rehayem, executive]

We are definitely happy with how the business is tracking. I mean, they are seeing no different to the rest of the asset finance market, some seasonal peaks and troughs. But outside of that, our business plan internally has been executed to the decimal point, but also the transition that we've had has been seamless, which is very important to note. Many know that when you acquire businesses, sometimes, there is a lot of friction and the likes, but we haven't had that. And we've been able to capitalize on a number of synergies that we would announce later on in the year. But for us, we're very comfortable with what we have been able to achieve.

[Operator]

Our next question comes from Minh Pham from Barrenjoey.

[Minh Pham, analyst]

Two questions, if I may. Similarly to previous questions, but maybe tackling it a different way. If we're looking at your exit margin of 2.29% and comparing it simply to the major bank retail margins, it's pretty much in line, if not a bit below. That seems low given your mix to nonconforming and asset finance. I understand you're expecting deposit competition should level the playing field somewhat. But how do you measure whether your pricing for risk properly and your margins are appropriate? The risk of adverse selection could be big.

[Mario Rehayem, executive]

Yes. No, look, it's a good observation, but a couple of things to note. First and foremost, and I think it's fairly well publicized that the NIM that you're seeing coming out of the banks at the moment is probably a little bit higher than what the average will be in the future. But outside of that, you have to remember that all of Pepper Money's loans are against secured assets. Banks pay in personal loans, unsecured and they pay in business loans or generate a much higher margin than a secured product. So they -- when they quote the name, the quote and their business on all products, where with us, we are 100% secured products, and there is a material difference in the NIM generated between secured and unsecured.

[Minh Pham, analyst]

Yes. I mean I was just looking at the retail margins there, but that's okay. Maybe on to the second question. On your net tangible assets per share, that's reduced over the half with a simple measure of net tangibles to loan book also reducing. The payout ratio has reduced, but I understand it's still within your target band. So I just wanted to confirm that your payout ratio hasn't changed and how you view your capital position in the current environment.

[Therese McGrath, executive]

No. Minh, our payout ratio, the intra-dividend was 32.5% as per the dividend policy of the company that we declared at the time of the IPO. We held the dividend payout ratio at 32.5%. If you may recall at the half, I did indicate that it looked like the business was shifting more to a 50-50 sort of split in terms of the operating profit, and that's why we've held the dividend at 32.5%.

[Minh Pham, analyst]

And you're comfortable with your net tangible position as well?

[Therese McGrath, executive]

Yes, we're. I'm very comfortable with the net tangible position of the company. We continue to grow, and we continue to manage all the capital within the business very prudently.

[Operator]

And our next question comes from Wei-Weng Chen from RBC Capital Markets.

[Wei-Weng Chen, analyst]

Just a few questions from myself. Just roughly on your mortgage inquiries. You said that you were down sort of 21% year-on-year in January. In February and March, sort of in the CCP inquiries increased. Was that just season -- is that seasonality impact there? And just maybe if you could comment on how February is looking relative to the PCP?

[Therese McGrath, executive]

That was market in terms of sort of the performance that we'll give it. So that's the Equifax market inquiries with them.

[Wei-Weng Chen, analyst]

Okay. So that's not your inquiries.

[Therese McGrath, executive]

You've got it right.

[Wei-Weng Chen, analyst]

Okay. And then just on the -- I guess there's been a bit of talk recently about your mortgage prisoners. Wondering if you've done any work to sort of understand, I guess, how much of your book could be characterized as such.

[Mario Rehayem, executive]

We -- I'll disclose that we monitor the book practically on a daily basis very thoroughly to make sure that we are feeding the information to our customer care unit with proactive engagement with our customers. We have always been at the forefront of making sure we have customers at mine. So what we do is we run an analysis to know those customers that may have -- if we look at the serviceability, may have taken through that buffer. And we proactively engaged with that customer to see what their household income status is like if they've still got their job, but more importantly, do they feel that there is hardship in the foreseeable future.Now the comfort we are getting from all the calls we are making is, first and foremost, our customers are still employed. Second call is that although our serviceability may indicate that there is -- there should be stress coming through, but they are comfortably being able to pay their loans because of their household income has either increased or wasn't disclosed because only one of the individuals was on the loan, not 2. So there is -- there is some positives coming out of our calls.Now in saying that, like I said earlier, you cannot expect to increase rates by over 300 basis points and not have some stress to come through the book. We are managing that on a per person basis. We don't look at it as a portfolio. We do line-by-line loan stress testing, and that gives us enough information to be able to sit down and have a discussion with those customers and give them many opportunities and options to be able to either continue meeting their repayments or show them options of other ways of dealing with it.

[Wei-Weng Chen, analyst]

Okay. Great. And then just last one. Clearly, I guess, it's a tricky time for nonbank lenders. So the reality is that the operators that are doing a lot less than yourselves. Just wondering if you -- there were any opportunities out there to maybe grow through M&A in this space? Is there any appetite in this uncertain macro to kind of go down that path?

[Mario Rehayem, executive]

Well, anyone that knows me knows that I'm always looking. So there's definitely many opportunities. And for us, we are always curious to see what type of opportunities that will marry up to our values and also making sure that there is strong inorganic opportunities by way of whether it's mortgages, whether it's asset finance, whether it's other areas that can combine our credit engine, our funding abilities and the like. So short answer is, we are always curious and looking for inorganic opportunities.

[Operator]

Ladies and gentlemen, with that, we'll conclude today's question-and-answer session. I'd like to hand the floor back over to Mario for closing remarks.

[Mario Rehayem, executive]

I'd just like to thank everyone for joining us today again, and we look forward to our first half results. Thank you very much.

[Operator]

And ladies and gentlemen, with that, we'll conclude today's conference call and presentation. We thank you for joining. You may now disconnect your lines.