Manx Financial Group — Rapid growth tempered by margin pressure

In H123, the group lent a record £182.6m, a 65% uplift (H122: £110.9m). Subsequently, this pushed NII up by 56% to £16.4m. Group NIM increased 1.5 percentage points to 8.2% due to the contribution from PAL. Conister Bank, however, experienced margin erosion of 6% as the bank continued to grow its deposits (to fund lending) and passed on rates to savers. The cost of funds for Conister Bank jumped to 3.38% in H123, more than double the 1.59% in H122. Although the majority of lending activities occur through the bank, its subsidiary PAL helped boost margins at the consolidated group level. PAL’s short-term lending structure, highlighted in our April Update note, means that yields are far higher than Manx’s conventional lending activities. PAL is able to turn over one-year funding from Conister Bank c 1.2 times, which provides a useful counterbalance since PAL’s lending reprices faster than Conister Bank’s traditional lending. The combination of faster repricing on the lending side and the faster turnover on the loans allowed group NIM to increase respectably.

The group attempted to soften some of the margin pressure through expanding the loan-to-deposit ratio, which stood at 103% in H123 (H122: 97%). Notably, the loan book was up 40% y-o-y to £343m and this volume growth drove core operating income up 36% to £15.6m.

The group continued to focus on restraining fee and commission expenses. In H123, fee and commission expenses represented less than 1.4%, or £3m, of advances compared to 1.2% in H122. However, weak investor sentiment persisted. As a result, commissions earned in its financial advisory business – £2.2m – were not enough to overcome the expenses, leading to a net fee loss of £0.8m. Operating expenses rose 41% to £10m, predominantly in the form of personnel costs as Manx continued hiring staff to facilitate the opening of its UK deposit-taking branch. As is the case with other lenders, the group also bore the cost of underlying inflation. Furthermore, Manx has embarked on a multi-year, multi-million-pound IT investment programme as it focuses on scaling up the business, improving customer-facing technology and obtaining the infrastructure to continue adhering to compliance policies. This will increase efficiency in the medium to longer term but act as a headwind to profit during the implementation period.

Relatively in line with loan book growth, impairment charges increased 45% to £3.3m. Common with other UK lenders, Manx has increasingly placed emphasis on prime lending. This has allowed moderation in its CoR. Group CoR rose 1.5 percentage points to 4.9%, partly due to front loading stage 1 provisions due to loan growth. Notably, CoR for Conister Bank remained in line at 0.1%.

With a combination of strong operating performance and CoR, PBT rose 30% to £3.0m. However, net attributable profit fell 11% to £1.9m as the minority interest from the six-month contribution from PAL was removed from the consolidated accounts (see Minority interest explanation and Exhibit 2 below for further explanation). Resultantly, EPS fell to 1.67p/share, down 11% from 1.89p/share in H122. However, positively, Manx has maintained a strong ROE with an annualised 17.1% (FY22: 17.4%) according to its own definition. Manx uses net profit – before minority interest is deducted – to calculate its ROE whereas Edison uses net attributable profit to shareholders (after the minority interest has been deducted). Edison’s annualised H123 ROE is 12.7%

In September 2022, Manx announced its 50.1% acquisition of PAL for £4.2m. Manx has the option to buy the remaining 49.9% for a variable cash consideration of two times average net profit of PAL, capped at £5m, by FY26 (see our last note in the ‘Further upside optionality of Payment Assist’ section for more detail). Under IAS 27, since Manx owns the majority of PAL, it must consolidate all of PAL’s revenues, costs and profit in the group accounts and then deduct the 49.9% of net profit attributable to minority interest after taxes.

As virtually all the group £0.6m minority interest charge relates to PAL, an acquisition of the minority interest would be highly accretive on current run rates and PAL is on track to deliver an annualised c £2.5m in profit in FY23 (or c £1.23m in profits attributable to Manx shareholders). Should Manx acquire the other half of PAL, the minority interest will be expunged, and all profits would accrue to Manx shareholders. We show this effect in Exhibit 2 where, if Manx had owned PAL wholly (and ignoring any additional after-tax financing cost), EPS would have appreciated 32% to 2.21p/share from its actual earnings of 1.67p/share. This is also 17% higher than H122 EPS.

We highlight that this is quite a simplified analysis. Should Manx acquire PAL for £5m in cash, its balance sheet equity would instantly decrease to £26m but rise to £29m by the end of the year as PAL’s earnings feed into equity and partially offset the £5m reduction. Based on this calculation, annualised ROE would be 18%, above our current annualised ROE of 12.7%. Additionally, it is worth noting that the debt-to-equity ratio, ie leverage, would also increase to 1.4x (currently 1.3x).

Over the past few years, as is a common theme with other UK lenders, Manx has shifted the loan book towards mostly prime lending. Although this implies a lower interest yield on assets, it means asset quality tends to be much better, resulting in attractive and less volatile risk-adjusted returns.

In Exhibit 3, we highlight that loans overdue 30 days as a percentage of gross loans have trended downwards over the last couple of years, and even dipped below 10% in H123 as the group grew prime lending rapidly. Coverage of stage 2 and 3 impairment allowances as a percentage of stage 2 and 3 overdue more than 30 days is robust at 46% (H122: 31%) and slightly above the 44% in FY22.

Additionally, total stage 2 and 3 loans in aggregate actually fell slightly in absolute terms in H123 versus H222. Exhibit 4 shows total stage 2 and 3 loans as a percentage of gross loans was 8.7%, significantly improved from 10.4% in H122 as Manx benefited from increased customer quality.

Management stated that the process of obtaining a UK banking licence is on track and it expects a response from regulators before the end of the year. A UK licence would give additional funding flexibility for the group and help balance the geographic funding profile. From a lending point of view, and despite the competitive UK market, a UK branch has promising potential. Manx estimates the market size for small and medium-size enterprise lending to be £15.7bn. Currently, Manx holds about 1.8% of UK market share while non-bank lenders make up 36%. Although Manx already lends to the UK, a deposit-taking branch would help boost its operations and brand image.

Manx has employed acquisitions successfully as a means of achieving growth in strategically attractive segments of the market. The group will continue to look for acquisitions to supplement its already strong organic growth. One of these markets is general insurance. Entry into the general insurance market will further enhance the earnings diversity of the group alongside providing cross-selling opportunities with its other subsidiaries.

From a macroeconomic perspective, the environment remains difficult to predict. Management believes that market conditions will remain challenging until Q224 – assuming market expectations that the UK would have reached the peak of the interest rate cycle and possibly begun the trek downwards.

However, as deposits are shorter-term products, they continue to reprice faster than loans and we expect to see further margin pressure. At the time of writing, Conister Bank is offering a 5.3% average savings rate on its fixed-term deposit accounts (with a maturity between six months and three years) and an average of 4.8% on its notice deposit accounts (maturities between 95 days and 180 days). Although we do not know the exact deposit mix, we can expect the cost of funding to increase from the current 3.38% as deposits are repriced to reflect updated rates. This will further put margin pressure on Manx as the longer duration loan book has a slower repricing cycle. Should rates rise, then one would project more margin erosion.

However, if rates come down as indicated by forward rate curves, Manx can expect its margins to expand favourably as deposits reprice faster to lower rates while it still collects interest on loans made at higher rates (and indeed some loans will still be repricing upwards). An additional offset to the current margin environment is PAL, which has a very short duration loan book. We highlight that for the year, management has guided to c £0.4bn in advances (FY22: £0.3bn), with a 20:80 split between the Isle of Man and the UK, which suggests it does not see a funding constraint for the business.

Manx currently has no consensus forecasts. In Exhibit 5, we have selected a varied list of small and mid-cap UK banks and specialist lenders with similar operations to Manx. We highlight that Manx trades broadly in line with peers on a 2023e P/E and P/BV basis. However, Manx has a better ROE by 3.8pp (compared to average) and 2.5pp (compared to average excluding Metro Bank), respectively. Manx is a small company, especially when compared to peers, and hence yields less as it is still in its growth stage and therefore less inclined to focus on returning capital to shareholders through dividends. Nonetheless, a 2.1% yield looks respectable.

In Exhibit 6, we graph ROE against P/BV for all peers and plot a line of best fit. We can see that in regard to the line of best fit, Manx is trading at a discount. To trade closer towards the line of best fit, Manx should be trading at a book value of c. 0.75x, or a price of c 20p, inciting a 7% uplift from the price at the time of writing.