S&U — Positioning for sustainable growth

S&U’s first-half results showed group receivables up 22% to £279.8m compared with the same period last year. This reflected continued but more moderate growth in Advantage motor finance as lending criteria has been tightened and the stepping up in property bridging loans as the pilot operation gains momentum. Revenue growth of 18% was outpaced by impairments as Advantage experienced a further increase in the rate of impairment but the cost of sales was contained with the number of new loans at Advantage 6% lower than in H118. This allowed pre-tax profit and earnings to advance by 17%, while the first interim dividend was increased by 14% as cover is rebuilt towards the target level of two times.

Three points within the Advantage results merit further discussion: the slowing of growth in new loans; the increase in impairments; and changes in accounting following the adoption of IFRS9 and IFRS16.

Advantage has a long track record with over 18 years of growth, and this experience and S&U’s conservative approach, which looks to develop the business sustainably, has fed into a progressive tightening of credit criteria in response to the results of an earlier experimental loosening and the more recent evidence of pressure on some customer’s real incomes. The company notes that it has recently further modified its own internal credit scoring to take account of the impact of new high-cost, short-term credit products (typically six-month unsecured personal loans) that have gained traction following the regulatory pressure on pay-day lending. This has resulted in a modestly lower level of new loans by Advantage in the period. Demand remains robust with loan applications up 16% to 510,000 and an e-signature system has eased the process of signing up and slightly raised the proportion of approved applications that have been signed up. Greater selectivity has nevertheless meant that the transactions rate versus applications has fallen from 2.8% to 2.3%.

The rise in impairments has lasted longer than the company expected but, as noted, credit scoring has been refined further and, subject to broader developments in the economy, the rate of impairment appears likely to stabilise and then reverse as tighter criteria progressively change the mix within the book of receivables. S&U indicates that very early evidence from repayments made by customers acquired during the first half does tend to support this expectation.

The adoption of IFRS9 with its expected credit loss approach resulted in a net £2.5m opening reduction in equity; this was in line with the previously indicated level and was taken straight to the balance sheet. Prospective potential differences in profit and loss impairment charges of the new standard compared with IAS39 are not clear cut, but where loan growth is rapid the rate of provision is likely to be higher (as intended) and volatility in provision levels at turning points in the economic cycle may be accentuated as loans move in or out of the lifetime provisioning categories. Importantly, cash flows arising from the loan portfolio will be unaffected by the change.

As part of the adoption of IFRS16, the grossing up of revenue and impairment charge by unpaid interest on impaired loans has been removed. For S&U, this was a small effect (£1.2m) in the first half, but it does introduce some distortion in comparing impairment and revenue ratios with earlier periods. As a way of sidestepping this, S&U cites a rolling 12-month risk-adjusted yield (revenue less impairment charge/monthly average receivables) for Advantage as a performance indicator. This showed a figure for the year to July of 25.4%, compared with 26.7% for the 12 months to February.

The property bridging pilot has continued to develop with net receivables at the period-end of £16.3m, compared with £10.8m at the year-end, while 61 bridging loan facilities have been arranged in the 18 months to end-July, of which 22 have been repaid. The average loan size is c £380,000, with an interest rate of just over 1% per month and an original term of between six and 12 months. Loans are made for refurbishment rather than rebuilding (avoiding risks related to timing and collateral value). Industry recognition of the business has grown, aiding origination of new business. The business achieved a profit of £0.28m, a swing of over £0.559m compared with last year’s loss. Investment in Aspen will be restricted to £20m prior to a decision (in the second half) on continuation of the pilot. As things stand, it seems likely that S&U will decide to go ahead with development of the business. A return on capital of around 12% is expected and, while this is lower than the figure of over 15% earned by Advantage, it is still seen as attractive taking into account the different characteristics of the businesses. Property bridging is focused on the quality of collateral and has the aspiration of avoiding bad debts almost entirely, while Advantage focuses on the credit quality of borrowers rather than the partial collateral provided by the vehicles financed and operates with relatively high impairment rates serving non-prime borrowers.

While there are uncertainties in the economic and political outlook, the current employment and consumer confidence background is generally benign for S&U (see Exhibits 2 and 3).

Sales volume in the new-car market has seen weakness (−4.2% in the year to end-August: SMMT data), but volumes in the used-car market where Advantage operates have been more resilient (Exhibit 4).The volume and value of used-car finance, as reported by the Finance and Leasing Association, has continued to rise, although the pace of growth has recently been lower than in earlier years (Exhibit 5 – used-car loan volume +7% in the 12 months to end-June).

Used-car prices, captured by BCA’s reports on auction prices, have remained broadly stable (Exhibit 6 showing fleet and lease and dealer part-exchange prices). In the event of an economic downturn, the used cars for which Advantage provides loans (average loan £6,157,H119) are likely to be less vulnerable to a softening in prices than new, higher-value vehicles.

Absent a marked worsening in the macroeconomic background, Advantage should benefit from a progressive improvement in the level of impairments as the tightening of lending criteria feeds through into the book of receivables. The existing high level of demand, the company’s relatively small market share and initiatives such as addressing the franchised dealership section of the market all suggest sufficient appetite for loans to allow Advantage to maintain or improve on the current growth rate without relaxing its credit standards.

On regulation, the FCA is due to issue its final report on its review of motor finance. The FCA has been focusing on affordability, the basis of commission arrangements, the quality and transparency of information provided to customers, and exposure to falling residual values. S&U believes it is well placed in each of these areas, given its close attention to regulatory developments and well-developed credit assessment process. Advantage pays fixed commissions to brokers, prides itself on the clarity of information provided and, with no exposure to PCP contracts and a relatively low value of vehicles financed, is not overly sensitive to fluctuations in residual values.

Turning to Aspen, the prospects here hinge on whether the board decides to move from a pilot project to developing the business further. As noted, the signs are positive and, if the go ahead is given, it seems likely that the board would wish to make sufficient investment in the activity to generate a material contribution for the group. This could mean a loan book rising to around £50m, generating a pre-tax profit of c £5m. For the moment, we have assumed the business will develop beyond the pilot stage, with a loan book of c £30m by the end of FY20.

Taking into account the trends shown in the first-half results, including the moderation in receivables growth and increased impairments at Advantage together with progress at Aspen and its move into profitability, our adjusted estimates are modestly lower than previously. Small variations in assumptions could offset the reduction.

In Exhibit 8, we set out the cash flow analysis that S&U provides, giving details of cash flow within Advantage highlighting the tapering down of the level of new advances in the last two halves, and the resulting reduction in the overall outflow both at Advantage and for the group as a whole.

Closing net debt stood at £121.4m, giving a gearing ratio of 78% compared with 56% for H118. On our estimates, gearing would increase to 79% by year-end and 87% at end-FY20. More funding will be sought in due course to lengthen maturity and match the evolving asset profile, assuming Aspen is developed further.

We have updated our comparative table (Exhibit 9) that includes a number of companies involved in non-standard lending or have motor finance as one of their activities. S&U trades on a below-average P/E and an above-average yield. The return on equity is noticeably above the group average, while the price-to-book is only moderately above the average value.

While our estimates have been slightly reduced, as outlined above we still look for the return on equity to move to more than 17% and 19% for FY19 and FY20, respectively. On this basis, an ROE/COE calculation still supports a valuation of 3060p (unchanged with the assumption of ROE of 17%, long-term growth 5% and cost of equity 10%).