Jenny Ruth: Pero looks for rich pickings

COMMENT

On March 5, Mike Pero sold his mortgage broking and associated businesses for $15 million.

Now he and purchaser George Gould are trying to convince investors that the company, Mike Pero Mortgages, is worth between $22 million and $25 million.

That's depending on whether the current float raises only the $7 million target or whether it gets to the full over-subscription level of $10 million.

As far as I can see, nothing much about the underlying business has changed in the meantime.

Even by the standards of other recent floats, these are incredibly rich pickings within an even shorter period than most.

Take Vertex, where the venture capitalist vendors paid about $12.8 million for the stake they sold for $60 million in less than two years (Gould later bought a 19 per cent stake in Vertex and is now its chairman but had nothing to do with the float).

Or Freightways, where the venture capitalist vendor paid A$187 million for the company's Australian parent and a year later sold the New Zealand subsidiary, keeping a 20 per cent stake, to recoup most of its initial outlay.

The Mike Pero prospectus says the float proceeds will be used to pay the estimated $483,000 expenses of the offer (that's 6.26 per cent of the funds raised if $7 million and 4.4 per cent if $10 million), reducing debt and "to position the company for future growth by complementary acquisition. No particular acquisition is contemplated at the present time".

A glance at the March 5 balance sheet is enough to tell anyone that there won't be much, if any, money left for acquisitions.

Gould's purchase was entirely debt-funded, guaranteed by his investment company Gould Holdings, and the only equity left in Mike Pero Mortgages is the $1.5 million Pero paid to buy back a 10 per cent stake in the company; Gould currently owns 90 per cent.

That's supporting $16.8 million in total assets. In other words, current equity is just under 9 per cent of total assets, a very thin sliver indeed. If the float raises $7 million, that would bring equity up to 50.7 per cent of total assets and if it raises $10 million, equity would be just under 60 per cent.

But what are investors actually buying? Undoubtedly, the company's biggest single asset is its brand. Accountancy firm KPMG has valued that at $13.2 million. On top of that is the fee and other income already in the pipeline; the amount due in the next 12 months plus the cash is valued at just over $3 million in the balance sheet while future trailer commissions are valued at $71,526.

According to the prospectus, 60 per cent of the company's revenue in the year ending June will come from brokerage and a further 26 per cent from trailer commissions.

Every time the company or one of its franchisees signs a client up to a mortgage, they receive a percentage of that loan, usually between 0.5 per cent and 0.8 per cent of the loan amount as an upfront commission from the lender.

A number of lenders also pay continuing "trailer" commissions over the life of the loan, or for a set period, typically around 0.125 per cent of the loan amount. The company takes about 37.5 per cent of the brokerage earned by its franchisees. (The prospectus shows franchisees outside Auckland pay $50,000 each while those in Auckland pay $70,000.)

Then there are other fixed assets such as office furniture, computers and cars in the balance sheet at $383,275. All that adds up to just $16.75 million.

Current liabilities are put at $2.7 million while those due later than 12 months are $12.57 million, mostly bank debt, $8.4 million owed to Westpac Bank, and $4.5 million in vendor finance.

The post-float value is implying an enormous value for the company's future prospects.

Assuming the company raises the full $10 million, outside shareholders will own 40 per cent of the company and Gould will be diluted to 54 per cent and Mike Pero to 6 per cent.

The prospectus does say it has taken into account the possibility the housing market may be slowing. After a 47.3 per cent jump in revenue in the year ended June last year, sales for the current year are projected to be up 28 per cent and sales in the year ending June 2005 are projected to grow only 8.8 per cent.

Net profit is projected to drop 11.8 per cent this year to $1.2 million, partly but not completely reflecting $154,253 in one-off costs, before rising 29 per cent to $1.55 million in the year ending June 2005. On a per-share basis, the float is richly priced. If the company raises $7 million, the new shares are priced at 18.28 times this year's earnings and 14.16 times next year's earnings. If the full $20 million is raised, the price rises to 20.83 times this year's earnings and 16.13 times next year's earnings.

But let's leave aside such questions and ask again, what are investors buying? Essentially, mortgage broking is about each individual broker arranging home loans for their clients and earning commissions from lenders for doing so. Mike Pero Mortgages currently has 35 brokers and it expects to sell a further four franchises between now and June 2005.

In other words, it is an intensely personal business, relying on individual relationships, and vulnerable to mortgage brokers choosing to leave.

Its nature is akin to stockbroking; most investors have a relationship with their stockbroker, not the firm they happen to be working for. The only recent example of a listed stockbroking firm was McIntosh, hardly a glowing example.

But there is a closer, if equally uninspiring, example of a dismal listing experience, that of an Australian mortgage origination firm, Homeloans. (Rather than placing loans with a range of lenders as brokers do, a mortgage originator sources funds from wholesalers such as AMS or Interstar and then lends the money to homebuyers and manages their mortgages.) It listed in March 2001 after a float of shares priced at A$1 each. They are currently trading at 35Ac.

Tellingly, the share price slide began in early 2002 and continued right through Australia's housing boom, a time when you would expect a related business to do well.

Other professional services firms such as accountants and lawyers have never become listed companies. Insurance firms and fund managers are listed, but insurance brokers and investment advisers aren't.

The Mike Pero Mortgages prospectus doesn't provide any details on the terms of the agreements it has with its franchisees, other than the current purchase price.

Chief executive Jeff Staniland, who has been in the job since the sale to Gould, says the company's normal franchise agreement has a seven-year term and it has a two-year restraint-of-trade provision within the city where the franchise was located and a six months restraint-of-trade provision nationwide.

Despite such provisions, by the very nature of the business, franchisees will come and go.

Miranda Caird, managing director of the Mortgage Choice franchise network which has 30 franchisees, has said that to begin with her franchisees need her company more than she needs them. But as they build up their businesses the balance tips the other way.

It's hard to believe this isn't the case for the Mike Pero Mortgages network too.

It has lost franchisees in the past. The company confirms it settled disputes with three former franchisees, one in August last year and the other two in September last year.

No matter what the restraint-of-trade clauses, the company can't stop its clients deciding to deal with the mortgage broker of their choice. Where there is a breach the company's remedy comes down to damages, which it would have to prove.

Certainly, life is more than possible after being a franchisee.

One Mike Pero franchisee, Sue Tierney, walked out of her franchise in July 2001 to start her own business, Mortgages by Design, and went on to win the Mortgage Broker of the Year award in 2002.

Presumably, Mike Pero himself has played a large part in the glue that has kept most franchisees within the business.

While he has a 10-year marketing agreement to continue promoting the company (for handsome rewards) he will no longer be involved in management.

Staniland comes with some pedigree in the business.

He was previously general manager strategy and projects at Perpetual Trust, a Pyne Gould Corp subsidiary, and was responsible for managing its half share in another broking network, Mortgage Express.