S&U — Adapting to the new environment

As expected, S&U’s first-half results were strongly affected by the onset of COVID-19, which restricted loan transactions in both motor finance and property bridging and resulted in substantial forward-looking impairment provisions at Advantage. Exhibit 1 provides a summary of the results with key points highlighted below. Comparisons are with H120 unless stated.

In Exhibit 2 we use details provided by S&U in the H121 presentation to show the impact of the pandemic on the payment profile in Advantage motor finance. Here S&U has included accounts on payment holiday as arrears to illustrate the effect on cash payments. The proportion of net receivables where payments are up to date declined by nearly 19 percentage points with the three and four months past-due categories seeing the largest increases.

At the end July point shown above, 12,918 of the total 63,472 live accounts in Advantage were on a payment holiday (mainly three months) but, as noted earlier, this had reduced to about 6,500 on original or extended payment holidays by the time of the results announcement (end September). For those customers who had previously taken a payment holiday, 86.4% were reported as making their contracted payments. Of those customers who have not taken a payment holiday, 95.8% were making payments as contracted (against a target of 94%). Overall collections at Advantage are running at 85% of due.

In addition to dealing with the immediate operational requirements post lockdown and tightening credit criteria early in the crisis, Advantage has been working to strengthen its systems, contain costs, enhance its product offering and develop partnership relationships. To this end, it is using its updated website to help handle customers applying for payment holidays, has developed automated communication to remind customers as they approach the end of their payment deferrals and developed categorisation of the portfolio with credit rating agencies so that support can be focused on customers most at risk of falling behind on payments. A review of credit rating agency costs has achieved a 45% saving, providing scope to move to the use of three rather than two agencies next year. Commissions paid to brokers have also been renegotiated with an average reduction of 9% against budget. An enhanced product line up, to be introduced shortly, is designed to attract customers with higher credit ratings. Advantage has also established an affinity relationship with one lender and is in negotiations with another. It is hoped that such relationships will enable the acquisition of better-quality business at a lower cost.

At Aspen property bridging, S&U report that a tightening of loan-to-value ratios earlier in the year has increased the quality of the book. The average loan value has been stable at £452,000.

In this section we start by tracking the recent development of the market background for Advantage and Aspen and then discuss the prospective influence of potential economic developments on the businesses.

Exhibit 3 shows the changes in used car transactions and new car registrations. This shows the severity of the lockdown-induced pause in transactions with new registrations, as is normally the case, showing the greatest volatility. Both new and used transactions have bounced back strongly, although note that the latest reading for used transactions is for June. The next chart shows data from the Finance and Leasing Association for used car financing where the latest data is for July, which saw a 9% y-o-y increase.

Exhibit 5 shows the number of non-residential and residential transactions with residential being most relevant for Aspen. Both have seen a post lockdown bounce with a stronger move evident for residential transactions. S&U point to the value of national transactions in August reaching a 10-year record (at £37bn) and instruction to offer times contracting markedly.

Exhibit 6 indicates that consumer confidence has continued to move up from its recent low point but still has some way to go and the latest reading (for September) is unlikely to have captured the impact on confidence of increasing regional restrictions on activity. Exhibit 7 shows the unemployment rate has yet to move significantly. It is normally a lagging indicator and has been cushioned in the current crisis by government job protection measures. Redundancies, however, have shown a noticeable increase. Both indicators seem likely to see increases as the government’s initial job support packages come to an end to be replaced by more targeted measures under the Winter Economy Plan, which acknowledges a need for the economy to adapt to a new normal.

The Bank of England’s monetary policy report estimated the peak number of those included in the Coronavirus Job Retention Scheme at over seven million in May, an average of two million in Q3 and about one million in its final month, October. Exhibit 8 shows a chart from the Bank’s Q320 quarterly (based on a Decision Maker Panel survey) also showing how the proportion of workers furloughed is likely to have already fallen substantially.

Having said this, the number of jobs relying on temporary government support is still significant and the economic slowdown and readjustment process the government now points to puts many jobs at risk. The Treasury’s compilation of independent economic forecasts below shows an average expectation of an 8.3% rate of unemployment in Q4 this year falling to 6.6% in Q421: the most pessimistic forecasts are for 12.7% and 8.6% respectively. These figures compare with the last-reported level of 4.1% for the May-July period. Note that the average value for Q4 is similar to the assumption used by S&U when assessing the level of economic overlay to apply to its provisioning level for motor finance.

Turning to how this background may affect S&U’s businesses, both motor finance and property lending have seen a pick-up in activity levels that on consensus views for the economy should be sustained. In the short term there is a risk that the path will be bumpy with the potential for partial or total lockdowns to slow economic progress.

Probably the greatest sensitivity for Advantage motor finance is the trend in unemployment nationally and the incidence within its customer base. Adverse developments here would reduce cash collections and could give rise to a further material forward-looking impairment provision, although we assume not at the level seen in the first half. So far, voluntary terminations of loans by customers have been stable, reflecting the importance of the car as a means of getting to work. However, if terminations were to increase this could also act as a brake on profitability.

Positively, tightened underwriting criteria have given rise to an increase in the average customer credit score. This measure is less certain as credit rating agencies do not report payment holidays but the level of first payments on new loans made in Q221 was 98.8% compared with the pre-COVID-19 level of 97.3%. Historically this indicator has had a good correlation with future credit performance. It will take time to gauge the impact on risk-adjusted yield (yield on loans less impairments) and the attraction of moving the portfolio permanently down the risk curve would be subject to competitor behaviour and hence pricing. However, S&U indicates the strategic direction is towards slightly lower risk business. It should be noted that any change in the mix of the portfolio would take place over a number of years given the original loan term is currently about 52 weeks.

For Aspen property bridging, the likely near-term ebb and flow in tackling COVID-19 and hence economic progress may result in fluctuating activity levels but, on a longer view, prospects in the residential market and property bridging appear promising given the unmet need for affordable housing for rent or purchase. Additionally, as a small business there should be scope for the business to expand significantly while still taking a conservative approach on credit risk.

Following the first half figures we have reinstated forecasts and set out a summary of these in Exhibit 10.

At Advantage we have assumed that new loan transactions increase from the 7,811 level of the first half to over 9,000 in H221 with FY22 seeing a rate of 22,000 new loans, possibly a conservative assumption. Overall book growth is expected to be affected by increased collections/bad debts as payment holidays end. The rate of impairments is expected to normalise to an extent following the provisions made in the first half but remain above the level seen pre-COVID-19, reflecting the more challenging economic backdrop. The cost-containment measures highlighted earlier are a positive factor in the estimates.

Exhibit 11 shows the segmental cash flow analysis S&U provides with its results. Looking at the motor finance section, the H121 slowdown in advances and the impact of payment holidays on collections (c £9m) are salient features feeding into the £18.0m cash generated before dividends during the period. Property bridging also generated cash with collections and debt recovery outweighing the reduced level of advances. As a result, net debt (excluding lease liabilities) reduced from £117.8m to £108.0m. Existing committed facilities of £130m provide good liquidity headroom.

Looking ahead, on our estimates, overall cash flow is expected to remain positive in the second half and then modestly negative in FY22 (c £4m) as loan book growth resumes.

Having reinstated estimates for S&U our updated peer-comparison table below now includes prospective P/Es for peers based on consensus estimates. The P/E comparisons are difficult to interpret given the impact of forward-looking provisions in the post-COVID-19 period. For 2020, not all the companies have reported numbers that capture this and the reduced profit or loss incurred where they have, are not a good guide to the likely future performance of the businesses. P/Es for 2021 should probably be viewed with caution too, given the potential knock on effects in that year also.

The price-to-book multiples are potentially easier to interpret as indicators of the market’s view of the longer-term potential returns each business may make or the risk that they will sustain a loss in net asset value. Here S&U has the highest multiple maintaining the high position it has held historically on this ranking. This is likely to reflect an historically high ROE (five-year average 16.3%) and the track record of growth and profitability at Advantage. Looking at this in another way with a ROE/COE model, if we assume a cost of equity of 10% and long-term growth of 2% then the share price at time of writing (1,700p) would be consistent with a return on equity of 11.4%, which is not substantially above the level we estimate for FY22 (10.7%) when S&U is unlikely to have fully recovered from the impact of COVID-19.