Secure Trust Bank — One-off impairment masks underlying PBT beat

The shift towards focusing on prime and near-prime products, as well as growing its distribution network, has enabled STB to drive strong originations and grow lending balances while keeping arrears at subdued levels.

In H123, STB grew its total lending balances by 15% compared to H122 (see Exhibit 1). New business in Commercial Finance slowed down significantly despite lending balances being up from H122, as we enter an elevated interest rate environment that is curbing business activity. The group recognised a £7.0m impairment charge, which originated from a long-standing debt issue. On the earnings call, management reassured investors that there are no other similar cases in the current loan book. Overall, PBT was 4% lower than in H122 at £16.5m. Excluding the impairment charge, it would have been £23.5m. On an annualised basis, this implies PBT would be £47m in FY23, 6% above our previous estimate.

In Retail Finance, new business grew 14.7% to £614m compared to H122, while lending balances increased 28.8% to £1,180m and generated revenues of £49.2m in H123 versus £35.9m in H122. Growth was underpinned by interest free products in furniture and jewellery, which attracts lower-risk customers but at lower net interest margins. Interest free lending now accounts for 86.2% of the lending book (FY22: 85.1%). The shift to prime lending has also allowed the group to keep impairments at stable levels even as lending continues to grow. Cost of risk for the period was 1.6% versus 1.4% in H122. Arrears for Retail Finance continues to remain low at 0.8%.

Additionally, AppToPay was introduced to a number of select retailers, which has marked STB’s entrance into the buy now, pay later (BNPL) market, where it expects to grow its market share. The app has been fully integrated into the suite of products offered by Retail Finance so it requires no IT integration by its retail partners. The group continues to leverage its retailer network to drive growth, which now stands at over 1,400 partnerships.

Vehicle Finance generated £250m in new business lending, up 41.7% in H122, achieving lending balances of £440m, an increase of 32.4% versus this time last year. As a result, the division generated a 30% increase in revenues to £29.0m.

Having tightened credit standards in 2022 and increased its prime lending activities, the cost of risk fell dramatically to 2.4% compared to 8.0% in H122. IFRS 9 provisioning was also a factor as the strong volume growth last year required upfront reserving. Arrears for near prime lending continue to be stable and has trended downwards towards 12.4% (FY22: 14.4%), while total arrears for vehicle finance – near prime and prime combined – dropped to 10% from 12.2% at the end of December. We highlight that the shift to more prime lending has resulted in lower net revenue margins to 11.4% compared to 12.9% in H122.

In common with its Retail Finance division, Vehicle Finance has a strong dealer network, which has increased from 560 in FY22 to 680 at H123.

In Real Estate Finance, new business lending was £252m, a modest 4.4% increase from H122. Lending balances grew respectably by 6.9% to £1,222m. but revenues jumped 30% to £35.1m on higher lending margins as STB is beginning to reprice the book against a headwind of rising UK interest rates. By the end of H123, 82% of the loan book was comprised of residential investment financing (FY22: 85%). With an average loan-to-value (LTV) ratio of 56.4%, the bank retains a good cushion against credit loss even if defaults rise should the economy weaken significantly.

Modelling provisions under IFRS 9, STB has increased its provisioning in stage 3 loans to £3.6m (H122: £2.2m). Consequently, impairment charges increased to £2.2m (H122: £0.2m) resulting in cost of risk rising to 0.4% from 0.0% in H122.

In Commercial Finance, rising interest rates, increasing cost pressures and slowing activity have affected volumes in the SME market. New business lending experienced a significant decline in comparison with H122, falling to £31.4m from £136m – a 76.9% decrease. Lending balances decreased at a slower rate to £316m from £360m in H122. However, total revenues increased 45.6% to £18m as revenue margins increased to 7.3% from 5.9% in H122. The rising yield is a result of the lagged effect of the bank passing previous interest rate rises (which had initially squeezed margins) onto borrowers. We also note that lending balances from the government Coronavirus Business Interruption Loan Scheme, Coronavirus Larger Business Interruption Loan Scheme and Recovery Loan Scheme are now running off, with the loan schemes totalling only £20m (FY22: £29m). This exposure has always been very low at STB and speaks to the company’s strong risk management culture.

In the half, the group took an impairment charge of £7.0m mainly related to a material loss of £7.2m on a long-running debt case that had not been previously included in Stage 3 loans in expectation of sufficient recovery. Management highlighted that this was a unique occurrence, and it does not expect such events to occur within the current lending book. Consequently, impairment charges for Commercial Finance increased to 4.1% (H122: 0.0%). Excluding the unique impairment charge, total write offs between 2015 and 2023 have been only 0.04% of average lending balances. Including the £7.2m charge, the average charge over the same period would still only be 0.6%.

Below, Exhibit 1 summarises the lending and impairment performance explained in the text above.

On the back of increased lending balances and previous interest rate rises, the bank generated interest income of £139m, up 53% from H122 (see Exhibit 2). Interest expenses, however, grew at a much steeper rate to £57.8m from £17.5m as the bank passed on higher rates to savers and also bore the costs of the £90m Tier 2 callable bond it issued earlier in the year. The bond pays a 13% fixed coupon and matures in August 2033. The bond issuance impacted the net interest margin by 20bp, but provides capital to facilitate growth in the business. Despite interest expense pressure, operating income grew 11% from H122 to £89.1m.

Operating expenses increased 9.7% to £50.7m from £47.0m in H122, broadly in line with the rate of inflation. STB continues to work on its cost efficiency programme, Project Fusion, which is on track to deliver c £4m in annualised savings by the end of the year and had achieved £2m in H123. The bank aims for a cost income ratio of less than 50% in the medium term. In H123 the cost income ratio was 56.9% and we forecast 54% at the end of FY23 including the remainder of Project Fusion which will fully annualise in 2024.

The one-off £7.0m charge in Commercial Finance mentioned earlier took impairments to £23m in the half, 28% larger than in H122. Excluding the charge, impairments would have been £16.0m, 11% lower than H122 despite a higher lending balance – a product of focusing on prime, higher credit quality consumers. The one-off charge increased group cost of risk to 1.5% (H122: 1.3%).

PBT was £16.5m, slightly below the £17.1m reported in H122. Stripping out the impairment charge, PBT would have been £23.5m. Annualising this, the bank would be on track for £47m in FY23, 6% above our previous estimate of £44.4m.

As expected, the bank also recognised a £1.5m loss associated with the disposal of the Debt Managers Services business. A further final c £0.5m loss is expected in the year.

Profit for the year was reported 42% lower than H122 at £11.1m. We do highlight that in H122, the group benefited from an initial profit of £6.1m from the disposal of Debt Managers Services, which influenced the bottom line. As a result, earnings per share was 42% lower at 59.4p/share (H122: 102.4p/share).

The board has approved an interim dividend of 16p/share, in line with H122 and representing a payout ratio of 27%, to be paid on 28 September 2023. In the outlook, management states it is optimistic that profitability will improve strongly in the second half of the year and into FY24.

We have significantly increased our lending estimates for both Vehicle and Retail Finance. For Vehicle Finance, reported lending balances in H123 were £440m, 5% higher than our FY23 estimate of £420m. Since demand for vehicles (and vehicle finance) continues to be elevated, and STB’s distribution network has grown, we have increased our estimates by 19% and 28% for FY23 and FY24, respectively. Similarly, Retail Finance lending was strong in H123, with lending balances of £1.2bn and already reaching our FY23 estimate of £1.2bn. As the bank expands its interest free lending operations and continues to leverage its retail network and grow market share, we expect that lending growth will be strong throughout the rest of FY23 and into FY24. Therefore, we have increased our lending balance estimates by 7% and 10% for FY23 and FY24.

After robust lending in H123 in Real Estate Finance, we have increased our lending balances by 7% in FY23 and 5% in FY24. We expect this trend to continue into the second half, but looking ahead we anticipate paydowns on loans to increase given indicators of forward inflation and interest rates so have conservatively kept balances flat in FY24.

On the other hand, Commercial Finance lending slowed down in H123 and the group remains focused on managing its existing customer base effectively. In anticipation of a continuing difficult environment for SMEs, we have taken into account the weaker H123 volumes and erred on the cautious side in our estimates for commercial lending. Therefore, we have lowered our lending balance estimates for FY23 and FY24 by 10% and 9% respectively in Commercial Finance.

Consequently, our estimates for total balances in FY23 and FY24 have risen to £3.4bn and £3.7bn for FY23 and FY24, increases of 6% and 8% from our previous estimates of £3.2bn and £3.5bn. We have provided a summary of our lending balance estimates in Exhibit 3 below.

Credit quality within the total loan book continues to be robust. Although the one-off charge in Commercial Finance materially affected profitability, management reiterated that it was a unique occurrence and is confident that no other situations are present in the current loan book. Additionally, despite market interest rate increases, the Real Estate Finance division, has only witnessed a very small number of clients in an active workout situation. STB can also work with customers on agreeing revisions to interest cover covenants, where deemed appropriate.

Moreover, in Vehicle and Retail Finance, impairments and arrears continue to be stable. Arrears in Retail Finance were stable at 0.8% (FY22: 0.8%) while the percentage of arrears in Vehicle Finance have reduced materially since FY22. In the near prime book, arrears dropped to12.4% from 14.4% in FY22, with total arrears in the Vehicle loan book falling to 10.0% from 12.2% in FY22.

In our estimates for the consolidated group in FY23, we have held impairments at 1.4% (see Exhibit 4). We have increased Real Estate impairments by 0.2 percentage points in FY23 to reflect the increase in impairments recorded in H123 but have left our FY24 estimate unchanged. In Commercial Finance, our impairment estimate is now 2.2% as we reflect the one-off impairment charge recorded in H123. Vehicle Finance impairments were particularly robust in H123, so we have reduced our impairment estimates for FY23 and FY24 by 3.1 and 1.1 percentage points, respectively. As the Vehicle loan book continues to incorporate more prime lending, we expect impairment levels in the segment to remain resilient. In Retail Finance, impairments were 1.6%, in line with our full year expectations. We expect impairment here to remain broadly stable with a slight increase of 0.1% in 2024.

In absolute terms, total impairments for FY23 are now reduced marginally by 3.7% to £42.8m because of the downward revision in Vehicle Finance, whereas we forecast an increase of 6.5% in FY24 to £51.5m as we have assumed a higher overall loan book than previously estimated.

Despite lower earnings because of the one-off charge and the headwind in FY23 interest expense from cost of the Tier 2 bond issuance, the outlook for STB is positive into H223. Lending growth remains strong and yields earned on loans should rise notwithstanding the shift to prime lending as rate increases are increasingly passed through to borrowers. Impairments continue to be stable and cost saving initiatives such as Project Fusion should be tailwinds to stronger profitability.

Following the upward revisions to our lending balance estimates, our forecasts for both FY23 and FY24 have increased (see Exhibit 5). We have increased our continuing PBT estimate by 1.2% in FY23 despite the H123 miss (due to the one-off impairment charge). Had the charge not occurred, annualised PBT would be £47m, above both our old and new estimates. We expect PBT growth to accelerate into the second half of the year with net interest margin expanding to 5.5% from 5.3% in H1. In FY24, we anticipate 11% lending growth, broadly stable impairment (on the continuing shift towards more prime lending) and an expanding net interest margin to 5.7% as the book reprices and the mix shifts towards higher rate Consumer Finance. Consequently, we have increased our FY24 operating income forecast by 8.3% to £221.8m.

Management reiterated its plans to reduce the cost income ratio and maintain good margins. Against an inflationary backdrop, the cost income ratio only moved up 1bp to 56.9% in H123 (H122: 57.0%). Alongside this, the bank is also expecting to deliver on the c £4m in annualised savings in the year from Project Fusion, having delivered half of this on a run-rate basis in H123. Taking everything into account, we have forecast a 5.7% increase in continuing PBT: we anticipate the cost income ratio to continue improving (we forecast 54% in FY23 and 52% in FY24) and net interest margin to gradually increase to 5.4% in FY23 and 5.7% in FY24, resulting from a higher weighting towards the Consumer Finance book and previous interest rate rises being passed through to loan yields.

In Exhibit 6 we compare STB to a peer group of mid-sized / specialist lenders in the UK. We observe that, on a calendarized basis, STB trades at a significantly lower 2023 P/E ratio despite having a competitive return on equity (ROE). Additionally, in 2024, with an ROE only 1.2 percentage points lower than the peer average, STB trades at a P/E ratio 48% below the average. Alongside this, STB offers a good current dividend yield of 6.3%, but is below the average of 8.1% as it is retaining more capital for growth.

Using our assumptions for FY23, STB is currently trading at a diluted P/BV of 0.36x (see Exhibit 7) and P/E of 4.0x. Based on our peer comparison chart, where we use calendarised 2023 P/BV and ROE, STB looks undervalued. On a peer valuation comparison, STB should be trading closer to c 0.6x P/BV or c 1,000p/share. This implies an upside of c 50% from the current share price. Management targets an ROE of 14–16% in the medium term and should this come to fruition, we would expect STB to trade closer to book value.