Arbuthnot Banking Group — Update 3 June 2016

On 27 May Arbuthnot Banking Group announced the conditional sale to institutional investors of a 33% stake in Secure Trust Bank, prospectively taking its holding to below 20%. This represents a significant step for both companies and is a logical response to the rapid growth in Secure Trust and the strategic opportunities that company is addressing. Key points from the transaction announcement are summarised below.

At the time of Secure Trust’s admission to trading in 2011, ARBB’s stake was reduced to 75.5% and in subsequent years, with further equity issue to support growth, the percentage shareholding declined to just above 50%. The compound growth of over 60% in Secure Trust’s loan book in these years reflected the opportunity presented by the fact that the major incumbent banks in the UK have been focused on managing capital and their core business. Prospectively, this opportunity to address underserved market segments remains in place as a major theme for Secure Trust, and ARBB (see recent notes for Secure Trust and ARBB).

In addition, the expansion in the number of challenger and specialist lenders in the UK market increases the potential for value-accretive M&A activity that could provide scale efficiencies and shareholder value for participants. The sale of Everyday Loans Group completed in April has probably provided Secure Trust with adequate capital headroom for several years of organic growth, but with ARBB as an investor rather than a quoted parent it will now be easier for Secure Trust to consider equity issue to support a strategic deal if the right opportunity were to arise and eventually to provide capital for organic growth when existing capacity has been used.

From ARBB’s perspective, it retains an investment in Secure Trust while management sees opportunities to deploy surplus capital, particularly in the development of a wider commercial banking business, which began in the second half of 2015.

Initially, this has been largely based on demand from entrepreneurial clients in the media sector to provide loans to their corporate structures, and the group intends to broaden this to the commercial property and professional services sectors as well. There are currently 12 specialist bankers involved in this area and the number could increase significantly as the business grows. The appointment of Ian Henderson as chief executive of Arbuthnot Latham in April brought pertinent leadership experience to the business, as he had previously been responsible for personal and mortgage lending at Secure Trust and prior to that chief executive at Kensington Group and Shawbrook Bank. Arbuthnot Latham has also been investing in a timely fashion in updating its banking system software, an important measure that incurred a cost of £1.1m for FY15, but should put the business in a stronger position to pursue more rapid growth in assets. The private banking area within Arbuthnot Latham is also expected to grow, but we assume this is likely to be at a steadier pace and to absorb less of the capital that the group will have to deploy.

As noted earlier, the group indicates an expected increase in surplus regulatory capital of £94.5m as a result of the sale and, as an illustration of changes in the shape of the balance sheet, we show an indicative adjustment of the year-end balance sheet demonstrating the effect of the deconsolidation of Secure Trust (STB), the completion of STB’s Everyday Loans Group (ELG) disposal and the sale of Secure Trust shares. While subject to adjustments on completion of the share sale and not reflecting the payment of a special dividend, for example, the illustration (Exhibit 1) shows a substantial increase in shareholders’ equity (from £123.5m to £293.5m) and, initially, a sharp contraction of the gross balance sheet totals with the removal of Secure Trust.

Subject to assumptions on deductions and other items, this could increase regulatory capital resources from the reported end-FY15 figure of £157.5m to a pro forma level of c £290m. In any case there is set to be significant headroom for deployment in the commercial bank, supporting development of the private bank, any acquisition opportunities and for distribution to shareholders (the previously announced 25p special dividend would be equivalent to £4m).

There can be no certainty over the manner and speed with which the surplus capital at ARBB will be deployed, although the current market background appears favourable for the development of the group’s commercial banking activity. In Exhibit 2 we set out one illustrative scenario showing how surplus capital could be employed in customer loans and generate a marginal return on capital of over 20%. The assumptions relating to net interest margin and impairment provisions are in line with the recent record and our existing estimate assumptions for ARBB.

In addition to the £37.1m of incremental earnings shown, the group would have the earnings generated by the existing business and its 18.9% share of STB earnings (c £5.5m on a normalised basis for FY16e).

If combined with the existing end-FY15 loan book and factoring in group costs, this would give an illustrative group ROE of over 12%, slightly ahead of our existing FY18 estimated return for ordinary shareholders on net assets post-minority (see Exhibit 3: Financial Summary, which is not adjusted for the Secure Trust share sale at this stage).

In our last note on ARBB we discussed an ROE/COE valuation that pointed towards a value of 1,656p based on a net asset value of 1,088p (adjusted for the ELG sale), assuming a return on equity of 12.5%, a cost of equity of 10% and growth of 5%.

Following completion of the Secure Trust share sale, our indicative pro forma net asset value (see Exhibit 1) comes out at 1,967p, after deducting the potential 25p special dividend – substantially ahead of the previous figure, and the current share price. Using our ROE/COE model, the current share price would be consistent with an assumed return on equity of just below 9% (in this case holding assumed growth at 5% reduces the calculated book multiple as the return is below the cost of equity). This return on equity appears a harsh assumption and, were management to envisage sustained returns at this level, then a prompt return of capital could immediately enhance shareholder value with a likely return to price that reflected a book multiple of at least 1x.

More positively, if the group can successfully deploy the surplus capital along the lines shown in our illustrative scenario in Exhibit 2, then a sustainable return on equity of over 12% could be progressively built into market expectations and this suggests a valuation trending towards nearly 3,000p.

Pending the completion of the sale of Secure Trust shares and the release of further financial details at the time of ARBB’s interim figures in August, we feel a valuation in line with our pro forma net asset value at 1,990p (rounded and before the indicated 25p special dividend) is appropriate.