Secure Trust Bank — Update 19 January 2017

Financials

Secure Trust Bank

Seeking profitable growth

Trading update

Financial services

19 January 2017

Price	2,329p
Market cap	£430m

Net debt/cash (£m)		N/M

Shares in issue	18.2m
Free float	79.9%
Code	STB

Primary exchange	LSE
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	7.8	(0.9)	(26.1)
Rel (local)	4.4	(4.1)	(40.1)

52-week high/low

3,150p

1,600p

Business description

Secure Trust Bank is a well-established specialist bank addressing niche markets within consumer and commercial banking. It is launching a non-standard mortgage business. Former parent Arbuthnot Banking Group’s shareholding is now less than 20%.

Next events

Full year results	23 March 2017
Dividend record date	14 April 2017
AGM	3 May 2017
Interim results	22 August 2017

Analysts

Andrew Mitchell	+44 (0)20 3681 2500
Julian Roberts	+44 (0)20 3077 5748

financials@edisongroup.com

Edison profile page

Secure Trust Bank is a research client of Edison Investment Research Limited

The Q4 trading update confirmed the business has been performing in line with management expectations and the full-year results should meet market expectations. Secure Trust Bank’s (STB’s) prudent approach was reflected in the announcement of greater caution in its consumer business including suspension of new unsecured personal lending. We have tempered our estimates for FY17 and FY18 but our updated valuation still shows a c 16% premium to the share price.

Year end	Operating income (£m)	PBT* (£m)	EPS* (p)	DPS** (p)	P/E (x)	Yield (%)
12/14	63.7	17.5	155.8	68.0	14.9	2.9
12/15	92.1	24.8	170.4	72.0	13.5	3.1
12/16e	121.2	31.9	141.0	74.0	16.5	3.2
12/17e	142.3	36.0	155.1	77.5	15.0	3.3

Note: *PBT and EPS on an underlying basis, excluding amortisation of acquired intangibles, exceptional items and share-based payments. **2015 DPS ex 165p special dividend.

Prudent approach in consumer finance

Reflecting its emphasis on growing prudently and profitably rather than prioritising scale, STB has tightened underwriting standards and increased prices in consumer and SME finance, and has stopped originating unsecured personal loans (UPLs). These steps have been taken to mitigate the potential for higher impairment rates in the event of an economic deterioration, including higher unemployment and inflation. Despite the current uncertain economic outlook, other market participants are offering unsecured personal loans at record low interest rates, which STB believes cannot be sustained.

Motor and mortgage outlook

As STB reported previously, competition in the motor finance sector has decreased as some of the more aggressive participants have pulled back and in one case withdrawn entirely. This should help maintain sustainable growth in this area. In mortgages, STB plans to go ahead with its product launch rather than wait for the postponed announcement of capital regimes by the Basel Committee. Larger incumbents have very low appetites for risk in the mortgage sector, so there is room for selective and disciplined challengers to earn attractive risk-adjusted returns. The launch will be modest initially allowing STB to fine tune its offering before making more significant capital commitments.

Valuation: Still above current price

We have maintained our FY16 estimates but used more cautious assumptions for FY17 and FY18 resulting in EPS estimates c 21% below our previous numbers. While we expect longer-term returns to strengthen, for consistency we base our ROE/COE valuation on our FY18e ROE (c 15%), which gives a fair value of 2,700p (formerly 3,400p), around 16% above the current share price.

Pre-close trading update

Trading during the fourth quarter of 2016 was in line with management expectations and the full year results are expected to meet market forecasts. STB indicates that the £116.8m one-off gain from the April 2016 sale of Everyday Loans (ELG) on top of the performance from continuing operations is likely to contribute to the tenth successive year with a return on required equity of about 30%. Highlights from the quarter include:

■

The move from AIM to the premium segment of the Main Market of the London Stock Exchange, covered in our last note.

■

STB tightened its credit underwriting standards and raised prices in consumer and SME finance to mitigate the risks of increased future impairments that could arise in weaker economic conditions and rising inflation and interest rates. Nonetheless, consumer and SME lending net balances have continued to grow, with the main drivers being less risky short-term retail finance, motor finance (where vehicles provide some security) and lower loan-to-value secured SME lending.

■

STB has said it will stop originating new UPLs but intends to re-enter the market once risk-adjusted yields become attractive again. Having previously drawn attention to concerns that other participants in the UPL market are underpricing risk, STB now views the market’s dynamics as unsustainable. Unemployment is at a historically low level and on some projections may rise modestly, while inflation has exceeded 1% and appears to be on a rising trend that is likely to be exacerbated in 2017 by the recent weakness of sterling. Despite this, STB reports that some lenders are offering record low interest rates on medium-term UPLs. STB reduced its UPL lending in H116 and will now suspend new lending altogether. The effect on FY17 earnings is expected to be modest.

■

The European Banking Authority issued guidance in 2016 that, under the Standardised Approach to Capital, lending to residential property developers should be risk weighted at 150%, although the British Bankers Association had argued for a 100% weighting, as previously used by many smaller banks. This will have an impact on capital requirements across the sector and STB is better-placed than many, having a substantial capital buffer in place and a relatively short-duration loan book. STB intends to raise its prices to reflect the new requirement, which its competitors will also have to do, and does not expect to suffer any competitive disadvantage. The ability of smaller banks to finance house building in the UK is likely to be curtailed.

■

The Basel Committee on Banking Supervision has postponed other decisions until March at the earliest following its consultations on capital regimes. STB had been waiting for these to be announced before launching its residential owner-occupied mortgage product but will not delay this any further. Management understands that one reason for the delay relates to proposals of a capital floor of up to 75% of the risk weights used under the standardised approach. That would substantially diminish the capital advantage enjoyed by systemic banks in favour of smaller ones such as STB. STB aims to lend at relatively low loan-to-value ratios to house buyers who may have an imperfect credit record and therefore may not be served by larger banks, but who are now low-risk borrowers with average incomes.

The closure of the current account product, disposal of ELG and move to the Main Market leave STB well placed to continue both organic and acquisitive growth in 2017. In the next two sections we set out our estimate revisions and provide updated valuation comments.

Financials

We have kept our loan book assumptions unchanged (Exhibit 1) with the exception of the unsecured consumer loans area, which accounts for c £75m of the loan book with an average term of c 2.5 years. We expect the outstanding UPL book to halve in the first year and fall to negligible levels by FY18.

Exhibit 1: Loan book development estimates

£m	2014	2015	2016e	2017e	2018e

Personal unsecured	88	74	75	38	0
Motor vehicles	138	166	249	298	358
Retail finance	117	220	320	399	499
Mortgage	0	0	0	75	300
Total retail lending	342	460	643	810	1,157

Real estate finance	134	368	400	600	810
Asset finance	5	71	150	203	243
Commercial finance	5	29	75	150	200
Total commercial lending	143	468	625	953	1,253

Other	43	32	58	58	58
Discontinued	94	114	0	0	0
Total lending	623	961	1,326	1,821	2,468

Source: Edison Investment Research, company data

We have also made slightly more conservative net interest income assumptions. Together with the UPL adjustment, this results in a 7-8% reduction in overall operating income estimates. In turn, with combined costs and impairment charges largely unchanged, this results in a 20-21% reduction in EPS. The changes to our estimates are summarised in Exhibit 2 and further details are included in the financial summary (Exhibit 5).

Exhibit 2: Estimate changes

	Operating income (£m)			Underlying PBT (£m)			Underlying EPS (p)			Dividend (p)
	Old	New	% chg.	Old	New	% chg.	Old	New	% chg.	Old	New	% chg.
2016e	121.2	121.2	0.0	32.1	31.9	(0.6)	141.9	141.0	(0.6)	74.0	74.0	0.0
2017e	152.3	142.3	(6.6)	46.4	36.0	(22.4)	196.3	155.1	(21.0)	95.0	77.5	(18.4)
2018e	188.6	173.6	(8.0)	62.1	48.2	(22.3)	265.0	208.7	(21.3)	107.0	82.0	(23.4)

Source: Edison Investment Research

Turning to the capital position, we estimate that the year-end FY16 common equity tier 1 ratio will be c 19% and for FY17 just below 14% (allowing for the change in risk weighting on property development loans).

Valuation

As in previous notes, we show a comparative valuation table including a selection of challenger banks and specialist lenders. The historical P/E and dividend yield are both above average at 13.5x and 3.1%, while price to NAV is slightly below average. The ROE is below average, reflecting the significant capital headroom at STB following the sale of ELG. Prospectively, we expect this return to increase with the pace depending on market conditions or, potentially, acquisition opportunities.

Exhibit 3: Challenger/specialist lender comparative table

	Price (p)	Market cap (£m)	Hist P/E (x)	Yield (%)	ROE (%)	Price to NAV (x)
Secure Trust Bank	2,329.0	430.3	13.5	3.1	12.7	1.9
Arbuthnot Banking Group	1,452.0	216.2	16.8	2.0	2.0	0.8
1PM	64.0	34.9	10.9	0.8	15.8	1.4
Aldermore	221.0	761.9	9.7	0.0	17.2	1.4
Close Brothers	1,437.0	2,157.5	11.4	4.0	17.7	2.0
CYBG	287.0	2,531.7		0.0	5.2	0.8
Metrobank	3,150.0	2,530.7		0.0	0.0	3.1
OneSavings Bank	323.5	786.4	9.5	2.7	29.1	2.5
Paragon	408.3	1,133.7	10.1	3.3	12.0	1.2
Private and Commercial Finance	25.5	43.4	8.5	0.0	13.4	1.8
Provident Financial	2,851.0	4,212.9	18.8	4.2	38.6	5.7
Shawbrook	245.0	613.7	10.2	0.0	20.0	1.7
S&U	2,090.0	250.0	3.6	3.6	15.2	1.9
Average			11.4	1.8	15.3	2.0

Source: Bloomberg, Edison Investment Research, company data. Note: Priced at 18 January 2017.

Exhibit 4 shows the price to net asset value against return on equity for the same comparators. At the extremes of the ROE scale, Metrobank’s valuation still reflects expectations that it will move towards its ROE target of 20% while Provident Financial’s high returns are matched by a valuation of 5.7x NAV. STB is broadly centrally placed but reaching or beating our forecasts of loan growth and returns on capital would arguably justify a higher valuation.

Exhibit 4: Challenger banks/specialist lenders P/NAV vs ROE

Source: Bloomberg, Edison Investment Research. Note: STB ROE is for FY16e, others are last reported.

In our last note we valued STB using a 10% cost of equity, 5% nominal growth and ROE of 18.5% based on our FY18 estimates. We now assume 15.5% ROE, a change proportional to our reduced earnings forecast. The indicated valuation is now 2,700p, which is c 16% above the current price of 2,329p. Reversing the calculation gives a market-implied ROE of 14.1%. We note that the reduced ROE figure used in our valuation partly reflects the more cautious assumptions that we have introduced and partly the prudent approach being taken within consumer lending at STB, and should be viewed in that light.

Exhibit 5: Financial summary

Year-end December	2014	2015	2016e	2017e	2018e
£m except where stated
Net interest income	49.2	78.9	107.2	128.2	159.2
Net commission income	14.5	13.2	14.0	14.1	14.4
Total operating income	63.7	92.1	121.2	142.3	173.6
Total G&A expenses	(37.5)	(50.5)	(68.2)	(76.1)	(91.3)
Operating profit pre impairments & exceptionals	26.2	41.6	53.0	66.2	82.3
Impairment charges on loans	(8.7)	(16.8)	(28.3)	(31.8)	(35.7)
Other income	0.0	0.0	0.0	0.0	0.0
Operating profit post impairments	17.5	24.8	24.6	34.4	46.6
Non-recurring items	0.0	0.0	0.0	0.0	0.0
Pre-tax profit	17.5	24.8	24.6	34.4	46.6
CorporationTax	(3.6)	(5.5)	(4.7)	(6.7)	(8.3)
Tax rate	20.6%	22.2%	18.9%	19.5%	17.7%
Bank tax surcharge	0.0	0.0	0.0	(0.8)	(1.7)
Profit after tax - continuing basis	13.9	19.3	20.0	26.9	36.6
Discontinued business	6.6	9.4	118.8	0.0	0.0
(Loss)/profit for year	20.5	28.7	138.8	26.9	36.6
Minority interests	0.0	0.0	0.0	0.0	0.0
Net income attributable to equity shareholders	20.5	28.7	138.8	26.9	36.6
Company reported pre-tax earnings adjustments	7.2	2.8	7.3	1.6	1.6
Company reported underlying pre-tax earnings (inc discontinued)	33.3	39.3	31.9	36.0	48.2
Company reported underlying earnings after tax and minorities (inc discontinued)	26.1	31.0	25.6	28.2	38.0

Average basic number of shares in issue (m)	16.7	18.2	18.2	18.2	18.2
Average diluted number of shares in issue (m)	17.1	18.5	18.5	18.5	18.5

Reported diluted EPS (p)	81.5	104.1	107.8	145.1	197.5
Underlying diluted EPS (p)	155.8	170.4	141.0	155.1	208.7
Ordinary DPS (p)	68.0	72.0	74.0	77.5	82.0
Special DPS (p)	0.0	165.0	0.0	0.0	0.0

Net interest/average loans	9.71%	9.97%	9.38%	8.15%	7.42%
Impairments/average loans	1.72%	2.12%	2.48%	2.02%	1.66%
Cost income ratio	58.9%	54.8%	56.3%	53.5%	52.6%

Net customer loans	622.5	960.6	1,326.0	1,820.6	2,468.2
Other assets	159.8	286.8	271.6	321.3	368.8
Total assets	782.3	1,247.4	1,597.6	2,141.9	2,837.0
Total customer deposits	608.4	1,033.1	1,312.9	1,784.9	2,419.8
Other liabilities	49.0	73.1	49.7	108.5	146.4
Total liabilities	657.4	1,106.2	1,362.6	1,893.5	2,566.1
Net assets	124.9	141.2	235.0	248.5	270.8
Minorities	0.0	0.0	0.0	0.0	0.0
Shareholders' equity	124.9	141.2	235.0	248.5	270.8

Opening shareholders' equity	61.6	124.9	141.2	237.1	250.6
Profit in period	20.5	28.7	138.8	26.9	36.6
Other comprehensive income	0.4	0.0	0.0	0.0	0.0
Ordinary dividends	(10.2)	(12.6)	(13.1)	(13.5)	(14.3)
Special dividend	0.0	0.0	(30.0)	0.0	0.0
Share based payments	0.5	0.2	0.2	0.0	0.0
Issue of shares	53.3	0.0	0.0	0.0	0.0
Share issuance costs	(1.2)	0.0	0.0	0.0	0.0
Closing shareholders' equity	124.9	141.2	237.1	250.6	272.9

Period end shares in issue (m)	18.2	18.2	18.2	18.2	18.2
NAV per share (p)	687	776	1,292	1,366	1,489
Tangible NAV per share (tNAV) (p)	641	738	1,253	1,327	1,450
Return on average tNAV	29.0%	25.2%	12.7%	12.1%	15.2%
Average loans	477.3	821.9	1,135.8	1,533.3	2,067.3
Average deposits	499.7	827.9	1,107.8	1,506.5	2,026.7
Loans/deposits	102.3%	93.0%	101.0%	102.0%	102.0%
Risk exposure	649.8	998.5	1,198.3	1,747.9	2,242.3
Common equity tier 1 ratio	18.7%	13.6%	19.1%	13.9%	11.8%

Source: Edison Investment Research, company data. Note: profit on sale of ELG in April 2016 of £116.8m is included with the discontinued business line for FY16.

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