Arbuthnot Banking Group — Update 10 May 2016

ARBB has a history dating back to 1833 when Arbuthnot & Latham was formed in Great St Helens. The group now comprises the private bank Arbuthnot Latham and Secure Trust, a retail bank with a growing commercial arm. Arbuthnot Latham offers private banking, whole of market wealth planning and a discretionary investment management service. Primarily a UK onshore bank, Arbuthnot Latham opened an office in Dubai in 2013 to provide access to the region. The bank is developing a commercial bank to serve the financial needs of entrepreneurial customers and SMEs. In April 2016 Ian Henderson was appointed as chief executive of Arbuthnot Latham and will join the board of Arbuthnot Banking Group. He joins from Secure Trust Bank where he had been responsible for strategic development and was chief executive for personal lending and mortgages. Previously he had been chief executive of Kensington Group and Shawbrook Bank.

Secure Trust was listed on AIM in November 2011; ARBB has a 51.92% stake in the company. Since the financial crisis, the STB loan book has been diversified and grown rapidly with an increasing emphasis on secured lending, a move that has been furthered by the sale of Everyday Loans Group to Non Standard Finance in the second half of 2015 (completed April 2016). The sale is expected to realise a profit of £115m that creates capital headroom to continue loan book growth with an emphasis on motor, retail and SME lending within the existing portfolio and additionally the development of the nascent mortgage activity, which management see as having the potential to provide a third leg for STB.

Prominent features of 2015 for the group were the sale of ELG and strong loan book growth, particularly at STB. There was a good pace of new client signings at Arbuthnot Latham accompanied by particularly strong growth in deposits and continued expansion of the loan book. Key data points included the following:

In the financial statement the discontinued activity is shown as a one line after tax entry. In the table below (Exhibit 1) we collate the operating income, pre-tax profit and underlying earnings per share for the continuing and discontinued activities.

We have reviewed STB’s results in our note Growing into its capital. Loan growth continued its rapid growth in 2015 with an increase of 73% (including ELG) taking compound growth since 2010 to 64% (see Exhibit 2). Within this the greatest growth in absolute terms was in the real estate finance and point of sale finance (Exhibit 3). The real estate loan book is spilt roughly evenly between funding for residential developments and residential investment finance (professional buy to let). In percentage terms the most recently established areas saw the fastest growth: asset finance (hire purchase and finance leases) and commercial finance (invoice discounting and debt factoring).

Net interest income grew by 49% (including ELG) in 2015, below the 68% growth rate of average loan balances reflecting mix changes and, potentially, distortions introduced by simple averaging of loan balances in a period of rapid growth. Reflecting this, the net interest margin was lower at 12.7% versus 14.0%. The impairment charge as a percentage of the average loan book increased from 1.9% to 2.3%, an increase from a low base that can be attributed to mix changes and rapid growth.

Funding policy is unchanged with limited exposure to wholesale and interbank funding. Fixed term, fixed rate customer lending is broadly matched with customer deposits on a similar basis. The average tenor of deposits has been increased to match the liability position, with term deposits accounting for 57% of the total at the year end, compared with 54% and 44% in 2014 and 2013 respectively. The cost of funds has benefited from trends in market rates as maturing deposits have been replaced at lower rates. The interest cost as a percentage of average deposits fell from 2.8% in 2014 to 2.6%.

STB raised £50m of fresh equity capital in the second half of 2014 to support further growth in the loan book and during 2015 the CET1 ratio fell from 18.7% to 13.6%. Adjusting for the ELG disposal, STB’s year end CET1 would have been 24.1%.

Profit before tax increased from £3.6m to £6.0m in 2015 (+65%). This progress was despite incurring a £1.1m cost relating to a new banking system being installed to support growth and service levels. Other unusual costs included £0.3m start-up costs for the new commercial banking business and £0.4m of costs arising from a planned purchase of a mortgage portfolio abandoned when it became clear that regulatory capital requirements relating to this would be double the level initially envisaged. Without these unusual costs profit would have been £7.9m.

Underlying this profit increase was a 21% increase in operating income reflecting in turn a 30% increase in net interest income and a more modest 3% increase in fee income. Drivers of operating income included a 15% increase in customer loans to £619m with a record level of new loans at £250m. Customer deposits increased by 53% to £897m, benefitting from the recruitment of new, high quality private bankers. As shown in Exhibit 4, this resulted in the loan to deposit ratio moving back closer to levels seen prior to 2014. Assets under management increased by 11% to £739m and, reflecting stronger prior year growth, average AUM was up by 18%.

In Exhibit 5 we have shown how the level of total assets and AUM taken together have increased and calculated the level of operating income as a yield on this base. This has declined somewhat in the earlier years shown, probably reflecting a mix effect, including variations in the loan to deposit ratio, but thereafter has been stable at between 2.4% and 2.5%. The yield on total assets alone has been stable at around 4.4%.

Below the operating income level, operating costs of £29.7m increased by 24%, reflecting in part the unusual costs mentioned above, the addition of new private bankers to the workforce and moves to new, larger premises in London and Exeter. Impairments relating to customer loans more than halved to £1.25m: the company report impairments as mainly relating to a legacy portfolio which has been resolved.

The rate of new client acquisition was healthy at 50 per month representing an increase of 20-25% on an estimated target client base of around 2,500.

The group highlights the purchase and sale of ELG as an example of management’s long-term approach to investment (in this case the investment was crystallised by an unsolicited approach from Non Standard Finance after roughly four and a half years of ownership).

The group has traditionally managed its balance sheet conservatively, particularly during the financial crisis avoiding areas of the market, such as unsecured personal lending, where risk /reward had become unattractive. Subsequently, in 2011 STB was listed and additional capital was raised for it through a rights issue. The company was therefore in a strong position to acquire ELG in 2012 for £1 and refinance the loan book of approximately £64m. The business returned to loan growth and added to its branch network, extending its geographical reach. Non Standard Finance disclosure shows that ELG’s receivables grew at a compound rate of 17.3% between 2012 and 2014 generating underlying compound revenue growth of 19.2%.

This set the scene for Non Standard Finance’s approach and the sale price agreed in December last year of £127m, including £20m worth of Non Standard Finance shares (an enterprise value to net operating profit after tax multiple of 18.1x). The transaction was been completed in April 2016 realising a profit expected to be more than £115m.

For the retail bank, STB, the overriding point is that it accounts for very small shares of the broader markets it is addressing and with the major incumbent banks dealing with capital issues and focusing on core areas there is good scope for challenger/specialist lenders such as STB to record strong profitable growth in the medium term.

Following the ELG sale, STB has significant headroom to expand its loan book. In addition to expanding its existing activities, in particular the relatively new commercial businesses, the company is preparing the launch of its mortgage business, which could eventually become a third leg for STB of similar size to the consumer and commercial activities.

At Arbuthnot Latham there should be further benefit from the expansion of the loan book that has already taken place and there is potential for further sustained loan growth albeit probably not at the level recorded in 2015. Many of the loans are arranged on a bespoke basis to suit the particular requirements of entrepreneurial clients. Linked to this, Arbuthnot Latham has launched a commercial banking service to clients in the second half of last year providing loans to their corporate structures enabling them to receive personal and commercial financial support from one source, cementing the relationship. This offering was based on client demand and was initially focused on the media sector but this will be broadened to the commercial real estate and professional services sectors too. To support commercial banking there are 12 specialist bankers, a number that could more than double as the business expands.

The macro background in the UK remains uncertain with GDP forecasts being trimmed against the background of lower growth expectations for the global economy. The Office of Budget Responsibility, as an example, has reduced its central forecasts by 0.4 and 0.3 percentage points to 2.0% and 2.2% for 2016 and 2017 respectively. The result of the EU membership referendum could add to volatility. However, if existing forecasts were to prove close to the mark, this would provide a favourable background for development of the loan books of the retail and private bank activities with the level of unemployment expected to remain muted suggesting impairments could remain at low levels and demand for loans healthy.

The difference between the 2015 result and our estimate and fresh, ex-ELG forecasts are shown in Exhibit 6. While earnings are expected to be diluted by the disposal this year we look for rapid growth in 2017 as surplus regulatory capital is progressively deployed through loan growth.

A key feature of recent years has been the rapid growth in the loan book, particularly at STB (see Exhibit 7). We expect the most rapid growth in the forecast period to come from the commercial area within STB driven by a combination of growth from real estate and the relatively new asset finance and invoice discounting and debt factoring books. We have allowed for an apparently steep build up in the mortgage book but, given management’s expectation that this could provide a third leg for the business and the scale of the overall mortgage market, there should be significant scope for further growth, even within STB’s non-standard target market. At Arbuthnot Latham the development of commercial banking should augment loan growth but given the potentially lumpy nature of this business, including loan repayments, we have cautiously assumed 10% compound growth over the period shown.

Our estimates for ARBB group net interest margin and the level of impairments (both expressed as a percentage of average loans) are shown in Exhibit 8. The reduction in net interest margin reflects the higher proportion of secured lending within STB, including the growth in the mortgage business from 2017. At Arbuthnot Latham we have assumed a broadly stable level of net interest margin. The level of impairments is expected to remain relatively low in the private bank at c 0.25% of average customer loans.

The group expense ratio (Exhibit 9) reflects our assumption that the growth in the loan book provides scale benefits with the initial expenses in some of the businesses falling away or being spread over a larger operating income base.

Turning to the regulatory capital position, the group’s Core Tier 1 ratio last year fell from 14.0% to 11.7% reflecting loan growth shown above and before the gain from the ELG sale is recognised. We estimate that the ratio could increase to 14.0% this year subsequently declining to c 11% by 2018 as loan growth absorbs regulatory capital headroom.

ARBB’s group pre-minority ROE was 14.6% last year and is expected to dip this year as the profit on sale of ELG bolsters equity before returning to c 14% by 2018 reflecting expansion of both the private and retail bank loan books. We estimate that new business is being written at a substantially higher return on equity, leveraging the group overhead, and over the next three years our estimates imply an average return of 27%. Management indicates a return of over 30% implying the potential for upside. In either case the group ROE should continue to expand beyond our forecast period, unless conditions were to change materially.

We include a segmental analysis of external revenues and pre-tax profits (ex-ELG) in Exhibit 10 and a group financial summary (Exhibit 13) can be found on page 9.

As a starting point we show a comparative valuation table including a selection of challenger banks and specialist lenders together with three wealth managers. The significant differences between the companies and their markets means that caution should be applied in making comparisons but we note that in terms of calendar 2016 estimated P/Es, Arbuthnot sits between the averages for the lenders and the wealth managers. Its price to NAV ratio is towards the lower end of the range but the ROE shown is also at the lower end of the range.

Looking at the relationship between price to NAV and ROE more closely we can see in Exhibit 12 that ARBB is very much in the pack on this measure, suggesting no clear valuation indication. However, this depends on the prospects for growth and potential returns. As an example, the arrow next to Metrobank shows how the market appears content to value it broadly in line with its target ROE. While ARBB and STB returns on equity will fall initially following the sale of ELG, they appear set to increase again as they build out their loan books based on available regulatory capital.

A ROE/COE valuation gives a value of 1,656p (c 10% above the current share price) based on a tangible NAV for 2015 of 1088p after adjusting for the ELG transaction, using a cost of equity of 10%, 5% nominal growth, a sustainable ARBB shareholder ROE of 12.5% (just above our 2018 estimate) and including the potential 25p dividend to which shareholders are still be entitled. The group ROE (including the minority interest) was 14.6% last year or 18.6% excluding surplus capital, pointing to the potential to increase the return on shareholders’ equity over time. A sum of the parts exercise that takes the market value of STB, applies a 10% holding company discount, adds Arbuthnot Latham at 14x earnings and capitalises central costs at 10x gives a slightly higher figure of 1,687p.