S&U — PBT ahead, encouraging volume trends

S&U reported FY24 PBT of £33.6m, down from £41.4m in FY23 on higher funding and regulatory costs and higher impairments in Advantage in H2. PBT was 2% ahead of our forecast as stronger revenues – up 12% to £115.4m – and better costs offset higher-than-expected impairments.

S&U has absorbed rapid Bank of England (BOE) base rate rises, increased inflationary and regulatory cost and a challenging UK economy and still delivered an 11.1% ROE in FY24 – above our 10% COE assumption. Encouragingly, net receivables grew to record levels at both Advantage and Aspen, and management noted particular strength in Q4 and a good trading environment in the current year. This receivables growth will feed into revenue growth in FY25.

We expect c 9% volume and PBT growth at Advantage in FY25, with Aspen growing PBT c 25% on 21% volume growth and margin expansion following continued investment in the business. For the group as a whole, our estimates translate into 11% PBT growth in FY25e, accelerating to 14% in FY26e as funding and cost pressures abate. This leads to a forecast ROE of 11.6% in FY25, rising to 12.5% in FY26.

The shares are modestly valued at 0.95x book, which indicates 32% upside from the current share price based on our projected 12.5% ROE in FY26e. We believe our ROE assumptions are conservative as we have not included any interest rate cuts in our earnings forecasts and the five- and 10-year historical average ROEs are well above our 12.5% assumption, at over 14% and 15% respectively.

S&U is an established specialist lender, with businesses addressing the non-prime and near-prime motor finance and the property bridging markets, and operates solely in the UK. It evolved into a home collected credit company in 1975 from a retail business originally founded in 1938 by the current chairman’s grandfather. Advantage Finance, the motor lending business, was founded in 1999 and the home collected credit business was sold in 2015 to Non-Standard Finance for £82.5m. This sale helped fund rapid growth at Advantage and the founding of Aspen, the bridging loan business, in 2017. The company has been listed on the London Stock Exchange since 1961.

Advantage motor finance has a record of strong, profitable growth over more than 25 years through various economic cycles. Aspen Bridging was founded in 2017 in Solihull and supports UK residential property development. The division been steadily investing in its team and distribution network. This has translated into a meaningful contribution of 14% of group PBT by FY24 while maintaining a prudent underwriting approach.

Both businesses focus on sustaining high levels of individual customer service, investment in technology and refinement of underwriting processes as competitive differentiators. The Coombs family owns c 53% of the equity and management takes a long-term, sustainable approach to the development of the group.

Advantage Finance is based in Grimsby and provides used car finance to subprime and near-prime borrowers. Distribution is 90% through brokers, 5% direct through dealers and 5% through refinancing for previous customers. S&U has relationships with the largest UK brokers including Carfinance247, Zuto, Evolution Funding, Jigsaw and Midland Credit. This gives access to both large dealership networks and smaller local dealers.

A typical loan currently is just over £8,150, with £14,500 repayable over 54 months including interest at a flat rate of 16.9%.

Since being founded in 1999, Advantage has exhibited a strong and consistent track record across economic cycles. Receivables hit a record in FY24 at £332.5m, representing a compound average growth rate (CAGR) of over 14% in the last 18 years, which includes the financial crisis and the COVID-19 pandemic. Over the same period, PBT has compounded at over 15% per annum.

This financial performance demonstrates the strength of the business model. All loans are underwritten and collected centrally, largely through direct debit. The Advantage web-based system is able to provide almost immediate in-principle lending decisions – less than 10 seconds for 95% of applications. The credit scoring and underwriting system, originally developed in conjunction with Experian, is under constant refinement, taking into account a range of data sources. S&U accounts for bad debts conservatively compared to the industry, as loans are transferred to IFRS 9 stage 3 provisions after just one month overdue, compared to the industry norm of three months. This policy stems from Advantage’s extensive data and analysis of payment trends and delinquencies over many years.

The use of a car often is the only realistic means of transport for S&U’s customer demographic in their daily lives of work, family and leisure. This essential customer need helps to create a resiliency in the client base. Advantage competes on customer service and works with customers when difficulties arise, hence the slogan ‘we see more than your score’. By working closely with customers, S&U is able to help the majority of its clients improve their credit scores and thus access to, and cost of, finance generally.

Advantage has been able to benefit from more difficult economic times in the past, for instance leveraging its strong internal systems during the post financial crisis credit crunch to underwrite profitably. The current period of extensive regulatory intervention around Consumer Duty, forbearance and discretionary commissions may also prove a longer-term benefit to Advantage. Indeed S&U management is looking to leverage the fallout as players with weaker customer service and outcomes and previous extensive use of discretionary commissions (Advantage never used these) pull back from the market.

S&U’s extensive technology investments are also able to reduce regulatory cost, which will add to its competitive advantage in an industry with heightened regulatory scrutiny. Examples include: AI screening of any customer complaints, especially given the publicity around current FCA investigations into collection and commission practices; voice analytics recording; and documenting every single call to customers.

Exhibit 1 below highlights the growth in key metrics at Advantage Finance since FY13. Receivables have grown more than sixfold, from £52m to £332m, and revenue has grown fivefold, from £21m to £98m. The revenue figure was affected in FY24 by higher funding costs on BOE base rate rises, higher inflationary and regulatory costs and accelerated IFRS provisioning, leading to a compression of margin to 29%.

Going forward, we conservatively do not include any interest rate cuts in our model, but it is worth pointing out that on our estimates a 50bp reduction in the cost of finance would increase FY26e PBT for the group by c 3.5%, all other things being equal (see the Sensitivities section below).

We expect some modest expansion of margin to 30% by FY25, as cost growth moderates and assuming a modest benefit from dynamic risk-adjusted pricing. Advantage expects a shift of lending towards lower-risk near-prime borrowers in FY25. Management expects this will balance headline yields against underlying pricing adjustments, but lead to lower impairments and a more attractive risk-adjusted margin.

Exhibit 2 above illustrates S&U’s success in growing Aspen since starting the business in 2017. From 2018, receivables have grown 12-fold and the division contributed a meaningful 14% of PBT in FY24 compared to 11% in FY23. The performance at Aspen last year is all the more impressive given the difficult housing market, with annual transactions averaging one million, down 19% on the previous year according to HMRC data.

We expect Aspen to continue to grow more strongly than Advantage and increase its share of group PBT from 14.3% in FY24 to 16.4% in FY26, as illustrated in Exhibit 3.

This growth is being fostered by a combination of factors:

From a cyclical point of view, the UK residential housing market has shown some signs of improvement, with stabilising interest rates and lower mortgage rates. S&U management expects market transactions to rise around 10% in 2024, with house prices rising 5%, and we are seeing evidence supporting this view from our market indicators (see Exhibits 12–15 later in this note).

S&U has been making strategic investments in the business. The team has expanded to 25 people from 21 two years ago, with increased expertise brought in on risk and recoveries for instance. Aspen is increasingly being recognised as a successful industry competitor and is building a strong brand in the marketplace. A key part of its distribution strategy is to continue to build sales channels and relationships with brokers. Aspen also aims to grow its network through participation at industry events.

Aspen is refining risk-adjusted pricing and focusing on the quality of borrowers and the underlying projects and maintaining conservative loan to value ratios (LTVs). This means working more with larger, repeat borrowers that should generate strong risk-adjusted returns for the business.

In a challenging environment, S&U reported PBT of £33.6m in FY24, down from £41.4m in FY23. Funding costs more than doubled over the year to £15.1m on higher interest rates, IFRS 9 provisions accelerated on slower payment rates in H2 at Advantage and additional regulatory cost was incurred around FCA initiatives on Consumer Duty and forbearance.

Despite this, PBT was c 2% ahead of our forecast, implying a 5% beat in H224. The main drivers of the better FY24 earnings performance were 2% better-than-expected revenues, 2% better cost of sales and 17% lower impairments in bridging finance. These were partially offset by 10% higher-than-forecast impairments in Advantage.

Underlying customer activity remained positive and was above expectations, with good momentum towards the end of the year. Total revenues rose 12% to a record £115m, as both Advantage and Aspen grew receivables 10% to record levels of £463m. The company delivered a very respectable ROE of 11.1% for the year (15.6% in FY23), and unlike some peers S&U is not in scope for the FCA investigation on discretionary commissions in the motor finance industry, which is an important differentiator in terms of regulatory positioning, in our view.

Exhibit 4 below illustrates the overall performance in the context of the last five years.

Revenues in motor finance grew 9% y-o-y as the number of new transactions moderated by 10% but the average loan increased in line with the company’s cautious approach to new lending during the year. Property bridging achieved rapid revenue growth of 34%: net receivables grew 15% to a record £130m and margins expanded as part of management’s pricing strategy. Management noted strong activity at Advantage in Q4 and improving housing market fundamentals for Aspen.

The strong revenue performance was more than offset by impairments, finance costs and administration expenses. Impairments in motor finance were the largest detractor in absolute terms, and grew by 81% or £10.4m on a weaker payment experience in the latter part of the year. IFRS 9 provisioning requires lifetime expected loss recognition upfront for delinquent loans, which accelerates the P&L impact of any deterioration.

The second largest negative impact on profit was the doubling in financing cost following interest rate increases. Finally, admin expenses rose 22% or £3.5m due to inflationary and regulatory costs as a result of numerous FCA actions in the industry as a whole.

EBITDA was commendably stable at £49.2m, but after finance costs PBT fell 19% to £33.6m. A further headwind from the rise in the corporate tax rate led to net profit and EPS both declining by 25%, to £25.4m and 209.3p respectively. The dividend per share was lowered 10% in light of the decline in earnings.

Despite the reduction in ROE from 15.6% in FY23, S&U’s track record of shareholder value creation was nevertheless maintained, with the company recording an ROE of 11.1%, above our COE assumption of 10%.

We have slightly raised our FY25 EPS forecasts by 2% to 230p and introduced an FY26e EPS forecast at 263p. We have maintained our DPS forecast for FY25e at 125p and estimate FY26e DPS of 130p in order to build dividend cover to 2x. This results in ROE rising from 11.1% in FY24 to 11.6% in FY25e and 12.5% in FY26e. We summarise our key estimate changes in Exhibit 5 below.

S&U reported FY24 PBT 2% ahead of our estimate, which implies a 5% beat relative to our H2 forecast. Both Advantage and Aspen contributed, with Advantage ahead of our estimate by 1% and Aspen ahead by 5% on net receivables growth of 15%. Exhibit 6 below summarises our estimates in more detail. We have modelled total receivables growth of 12% in FY25e and 9% in FY26e, which takes into account the continued good demand in Advantage as well as strong double-digit growth in Aspen given the pipeline referred to by management, investment in the team’s capabilities and expected stabilisation of interest rates. We expect the volume growth to feed into higher revenue growth of 15% in FY25e and 9% in FY26e.

Our key assumptions at Advantage include 7% growth in the number of transactions in FY25e to 23,000, with a somewhat higher average advance of £8,500 (£8,125 in FY24) as the company positions itself toward the near-prime customer. We maintain those estimates for FY26e. We expect Advantage to roughly maintain revenue margins with some slight underlying repricing offset by a shift to lower-risk customers.

At Aspen, we model high-double-digit revenue growth on strong receivables growth as well as the benefit of some repricing at Aspen’s book. We increase the average advance in both FY25e and FY26e to £900,000 (£881,000) in line with the company’s policy of pivoting towards larger, higher-quality borrowers.

FY24 was affected by both ongoing cost inflation as well as additional regulatory cost associated with FCA investigations into collections procedures. As inflation is now moderating and the FCA cost has been absorbed, we expect EBITDA and operating profit to grow in excess of revenues, both at 18% in FY25e and 14% in FY26e.

We model finance expense conservatively without assuming any market implied forward rate cuts (currently 25–50bps) and project an average cost of debt of 8% in line with H224 in both FY25e and FY26e. Should short-term interest rates fall, that would be a positive for interest margins, revenue and profit at S&U. Debt balances are expected to rise to fund receivables growth, hence finance expense is projected to grow 33% in FY25e constraining PBT to 11% growth as the average cost of debt flows into the full year figures. We expect finance expenses to moderate in FY26e, resulting in 14% PBT growth. Following the increase in the UK corporate tax rate last year to 25%, there is an additional 1% impact in FY25e, which limits net profit growth to 10% before accelerating to 14% in FY26e in line with PBT.

We summarise the cash flow of the business below in Exhibit 7. S&U’s finance receivables are funded by a combination of borrowings and equity. One can expect there to be cash outflow on new business as the company grows and invests in additional receivables, partially offset by collections performance. This stems in particular from Advantage as loans and interest are repaid on average over a 4.5-year term. Exhibit 7 below shows the cash flow development of the motor and bridging businesses over the last few years. The cash flow strain in FY24 was much lower than in FY23 mainly due to slightly lower new business in motor finance, as S&U operated a cautious approach to lending combined with excellent collections performance in both motor and property bridging.

Advantage is a major source of dividends for the group, with £15m paid to the group in FY24. However, we can see that Aspen’s contribution is beginning to grow and we would expect that trend to continue in the medium term due to our faster earnings growth forecast. The overall increase in net debt was £32m or +16.5% in FY24, which will likely accelerate a little in FY25 as receivables growth builds. As S&U has £280m of committed available facilities, the financing position looks comfortable.

The UK economy remains subdued, with slow growth and elevated interest rates. On the other hand, inflation has been gradually declining and from April 2024 there will be a c 10% rise in the Living Wage, an 8.5% rise in the State Pension due to the ‘triple lock’, a 2% cut in National Insurance rates and a 12% average drop in the energy price cap. These are important factors that should help support UK households, and hence demand for housing and motor finance and overall credit quality at S&U.

Exhibits 8 and 9 below illustrate expectations have not changed dramatically for UK GDP growth in 2024, which remains very low at 0.4%. More positively, expectations for both inflation (2.1% close to target) and unemployment, have drifted downwards without affecting the overall growth expectation. In 2025 forecasts envisage a moderate improvement in GDP growth to 1.3%, with stable unemployment and CPI. Thus, based on current forecasts, the economy is likely to remain sluggish over the next two years but with some benefit from lower inflation and potentially interest rates, with the market currently discounting 25–50bp of cuts by year-end 2024.

Consumer confidence (Exhibit 10) has continued to trend upwards from a low point in September 2022 around the time of the ‘Truss mini budget’ and in an environment of surging inflation, particularly household energy costs, which peaked in August 2022. We attribute the recovery to relatively stable unemployment (Exhibit 11) and recovering incomes, which are now rising in real terms with further increases coming through from the Living Wage rise (+9.7%), state pensions (+8.5%), reduction in National Insurance (-2pp) and declining energy bills (-12% average price cap). The uplift in redundancies (Exhibit 11) has not fed into unemployment and the level is in line with the last 10 years. Again, we would regard this data as supportive to consumer lending activities.

Overall indicators for the used car market are supportive to our lending growth assumptions, with year-on-year strength in transactions and stabilising values. Exhibit 12 shows monthly used car transactions, with the usual seasonal decline into the last quarter, but Q4 CY23 volumes were c 8% ahead of the same quarter in 2022. We can also see similar resilience in Exhibit 13, which shows used car finance through dealerships. One would expect a seasonal recovery in Q1 CY24 and S&U management has noted a strong start to trading this financial year.

The SMMT used car price index was down 8% y-o-y to the end of March 2024 (Exhibit 14),but has shown some stability in recent months with a quarter-on-quarter increase of c 1.4% in Q1 CY24 (Exhibit 15). This would indicate some resilience in demand for vehicles, which ties in with S&U management’s commentary on customer demand at Advantage and should be supportive of collateral values against receivables.

Although Aspen is not directly linked to the housing and mortgage markets, its borrowers depend on being able to complete projects, sell them on time and then recycle capital. Hence, a healthy UK residential housing market supports volume growth and reduces credit risk at Aspen.

UK residential housing data has been improving from depressed levels. Mortgage approvals for individuals for house purchases increased 40% and 41% y-o-y and 7% and 8% m-o-m in January and February 2024, continuing the recovery from the low point in January 2023 (Exhibit 16). Levels of activity remain below those pre-pandemic, leaving potential for further recovery.

The improvement in transactions and approvals will have been helped by mortgage rates easing c 150bp since August 2023, as shown in Exhibit 18, as well as improving consumer confidence as mentioned earlier. The improving housing market indicators provide weight to S&U’s management’s confidence in the pipeline and ultimately good volume growth at Aspen while maintaining underwriting standards.

We base our valuation on an ROE/COE model, which is very common within the financial sector. The sector is highly regulated and competitive, thus sustainable growth depends on the ability to generate capital. We assume a COE of 10% and a long-term earnings growth rate of 2%, and based on our assumed 12.5% ROE in FY26, the implied valuation is 2,432p (2,142p previously). This represents an uplift potential of 32% compared to the current share price. We believe our ROE assumption in FY26 is conservative as S&U has generated an ROE in excess of 15% over the last 10 years, but we believe this assumption is appropriate given the current UK economic outlook.

S&U is a UK- based specialist lender operating in consumer finance and property bridging finance. Thus in the near term, its fortunes are closely tied to the health of the UK economy. Personal income and employment trends drive demand for its motor finance products and derived-demand for bridging finance. Similarly credit quality is based on customers’ ability to pay. Like most finance companies, S&U relies on debt funding along with equity to fund its receivables and is therefore also sensitive to the cost of borrowing in the market.

S&U has a high level of variable costs, including funding, administrative and sales costs and credit costs, which means that changes in volume will tend to flow through to PBT (perhaps with a little operational leverage). This has been borne out over the longer term, as compound PBT growth of 15% over 18 years has slightly outpaced receivables growth of 14%.

In light of this, we model sensitivities to impairment charges and interest rates in isolation in Exhibit 19 below. Advantage is the largest business and clearly drives most of the impact.

A 50bp instantaneous reduction in average funding costs (with no impact on asset yields) would increase group profit by c 3.3% relative to our estimates in FY25 and FY26. The reverse would be true for an increase. As we have mentioned elsewhere, we have not assumed any interest rate cuts in our model, while the market is currently discounting interest rate reductions of 25–50bps by the end of calendar year 2024 and further reductions beyond into 2025.

A 5% lower impairment charge in isolation would increase group PBT by 3.7% in FY25 and 3.5% in FY26e compared to our current forecasts. Again, the reverse would be true for a 5% increase in impairments.

These sensitivities are not particularly high in our view and the impact is lowered due to S&U’s strong margins and efficiency. In reality, management at S&U would react to major changes in the environment to benefit the company.

Over the longer term, sustainable growth and returns are driven by S&U’s ability to win profitable customers based on its high level of service quality and efficiency, which S&U has demonstrated over many years.

The UK financial sector is heavily regulated and the FCA has become more interventionist in recent years. The FCA is particularly concerned with Consumer Duty, forbearance and more recently discretionary commissions in the motor finance industry. Such investigations can result in significant costs: regulatory cost in terms of additional compliance and monitoring requirements, increased cost to handle customer complaints and potentially fines and legal redress costs.

The market has been concerned with the potential financial impact of the discretionary commissions investigation, especially given the regulator is looking back to lending from 2007. The practice has led to some customers at some lenders paying higher interest rates than necessary as dealers were incentivised to offer these loans.

Unlike some peers, S&U has never paid discretionary commissions at any time, which takes it out of the scope of that investigation. Moreover, the company has always followed a high-service client-focused model, which we believe shows up in comparative statistics on the numbers of complaints to the Financial Ombudsman Service (FOS) and the percentage of complaints upheld by the FOS. Exhibit 20 illustrates the very strong position of S&U compared to peers in the motor finance industry.