Secure Trust Bank — Update 8 November 2016

STB is a well-established specialist lender that has traditionally focused on providing banking services to customers who may not have been well serviced by the large incumbent banks. A subsidiary of Arbuthnot Banking Group (ARBB) since 1985, it became independent in June this year following a sale of shares to institutional shareholders that took ARBB’s stake from 51.9% to 18.9%. Floated on AIM in 2011, STB shares were recently admitted to the premium segment of the Official List and began trading on the Main Market of the LSE on 12 October. Lord Forsyth, who joined the board of STB in 2014, succeeded Sir Henry Angest, also the chief executive of ARBB, as non-executive chairman on 19 October.

The pace of loan growth has been particularly rapid since the financial crisis (59% annual compound 2010-H116), with greater diversification as the scope of the business has been expanded organically and through acquisition. The current lending products include motor, retail point of sale and business finance (which includes real estate finance, invoice discounting, factoring and asset finance). A greater focus on secured lending was accelerated by the sale of Everyday Loans Group (ELG), announced last year and completed in April this year. A first charge, owner-occupier residential mortgage proposition is expected to be launched early next year.

The sale of ELG generated a substantial profit (£116.8m after tax), providing capital headroom (a common equity tier one ratio of 20.1% at mid-year) to support planned further substantial organic growth. Management has indicated that it aims to diversify its lending further to achieve three broadly equal legs to the business: consumer, business and mortgage lending.

Management has also made clear that it will review opportunities for inorganic growth and the growing number of specialist lenders/challenger banks may well provide scope for accretive consolidation at some point. In this event, the existing surplus capital could be helpful but the changes to STB’s ownership structure and its move to the Main Market should facilitate any future equity issuance and increase its range of strategic options.

Trading in Q3 was in line with the board’s expectations. We believe the update is also consistent with our forecast of strong growth from continuing businesses. We have made only a minor upwards adjustment to near-term costs in relation to the Main Market listing and ongoing investment in the new deposit platform and planned mortgage offering. In particular, we would note:

Examining the average daily level of trading in STB shares (to 8 November), volume for the brief period since Main Market listing (12 October) has been nearly double the prior 12-month period although this included one day of particularly high volume and taking the period to 28 October shows a mid-teens percentage increase. More broadly, as shown in Exhibit 3, the level of activity appears to have picked up since May when Arbuthnot Banking Group announced the proposed sale of six million STB shares and STB confirmed its intention to seek a Main Market listing. While this period is too short for a proper assessment, the indication of increased liquidity suggests part of the rationale for the move to the Main Market is being achieved and this should also contribute to interest from a broader potential investor audience.

As noted above, the only changes to our estimates are small adjustments to capture ongoing costs related to the Main Market listing and investment in the deposit platform. The resulting profit and earnings per share numbers are shown in Exhibit 4.

We have left our expectations for loan growth and operating income in place and for reference show our assumptions for development of the loan book in Exhibit 5 below. Points to note include the 38% compound annual growth in the overall loan book over the three forecast years, the initial growth in the new mortgage business and still strong growth in the real estate finance book. We have noted above the cautious approach to areas of lending being taken by management and, as market conditions change, this could mean the mix of growth changes or, in the event that the general economic background worsens materially, a slower overall pace of growth.

Even if there were a period of slower growth to ensure the quality of the loan book is protected, on a longer view the potential for growth in the areas STB is addressing appears good given the retrenchment to focus on core areas by the large incumbent banks.

Before examining our comparator table and ROE/COE calculation it is interesting to review the recent price performance for our selection of challenger and specialist lenders (Exhibit 6). If we look at the moves from 12-month highs (last column) then Aldermore, Shawbrook and OneSavings Bank are among those with weaker share prices with exposure to buy-to-let, commercial mortgages and SME lending potentially contributing to share price declines in a period of uncertainty over the economic outlook before and after the vote for Brexit. STB has also seen a decline of over 30% from its 12-month high, arguably a somewhat harsh treatment in view of the relative diversification of its loan book. The bank’s plans to grow into its enlarged capital base and immaturity of parts of the loan book can be seen as carrying risks but STB’s longevity and the experience of the management team are potential mitigating factors.

Exhibit 7 updates the comparative valuation table we have used in previous notes. The companies vary by size, business mix and strategy but provide some context for assessing STB. The historical P/E ratio is above average, as is the yield at 3.3%. The price to NAV ratio is just below the average while the return on equity (we have included here our estimate for FY16) is below average, reflecting STB’s capital headroom. The 12.8% ROE falls within a wide range with Metrobank just edging into profitability in Q3 on an underlying basis and well-established Provident Financial earning a return not far short of 40%.

The chart below, plotting price to net asset value against return on equity, gives a sense of how the market is valuing these lenders given the returns shown. Even though we have reflected the underlying profit reported in Q3, Metrobank is still an outlier but would be broadly in line once it earns its target ROE of 20%. At the other end of the scale it would appear that the high returns earned at Provident Financial are well recognised by the market. STB occupies a position ‘in the pack’ but delivery of our estimates for loan growth and return on capital (over 18% in FY18e) suggest the potential for a higher valuation. Other challengers also target growth and higher returns so the prospective relative positioning will depend on how well each company does in implementing its plans.

Our ROE/COE valuation for STB is essentially unchanged from when we last published given we have only changed our estimates marginally. Using a 10% cost of equity, nominal growth of 5% together with a return on equity of 18.5% (similar to our estimate for 2018) the value indicated is c 3,400p, 53% above the current share price. Reversing the calculation the current share price, all else equal, the market is discounting an ROE of only 13.8%.